Global liquidity risk in the foreign exchange market

Using a broad data set of 20 US dollar exchange rates and order flow of institutional investors over 14 years, we construct a measure of global liquidity risk in the foreign exchange (FX) market. Our FX liquidity measure may be seen as the analog of the well-known Pastor–Stambaugh liquidity measure for the US stock market. We show that this measure has reasonable properties, and that there is a strong common component in liquidity across currencies. Finally, we provide evidence that liquidity risk is priced in the cross-section of currency returns, and estimate the liquidity risk premium in the FX market around 4.7 percent per annum.     

Joint dynamics of foreign exchange and stock markets in emerging Europe

This paper proposes an ideal specification for studying joint dynamics of emerging stock and foreign exchange markets, and applies it on European emerging markets where this interaction is of particular significance due to large external deficits. Results show that global developed and emerging stock market returns account for a large proportion of the (permanent) comovement between the stock index and currency value. The residual interaction after controlling for global indexes is small. The sign of the currency-stock market relationship is driven by dependence on foreign capital (predominantly positive for countries which are net receivers of foreign portfolio capital) and depth of the local stock market. Bank of Russia's intensive involvement in the currency market delays Ruble's response to global information. Emerging European currencies predict reversals in global equity indexes several months ahead.     

Day-of-the-week effect in the Taiwan foreign exchange market

This study uses stochastic dominance with and without risk-free assets to examine whether trading days can affect patterns of the day-of-the-week effect in the Taiwan foreign exchange market. Our results generally indicate that higher returns appear on the first three days of the week across different trading-day regimes in the Taiwan foreign exchange market, confirming day-of-the-week effect. Allocating part of investors’ assets in risk-free assets is useful in distinguishing returns among weekdays for all currencies.     

Can Markov switching models predict excess foreign exchange returns?

This paper merges the literature on technical trading rules with the literature on Markov switching to develop economically useful trading rules. The Markov models’ out-of-sample, excess returns modestly exceed those of standard technical rules and are profitable over the most recent subsample. A portfolio of Markov and standard technical rules outperforms either set individually, on a risk-adjusted basis. The Markov rules’ high excess returns contrast with mixed performance on statistical tests of forecast accuracy. There is no clear source for the trends, but permitting the mean to depend on higher moments of the exchange rate distribution modestly increases returns.     

News announcements and price discovery in foreign exchange spot and futures markets

This paper studies competition in price discovery between spot and futures rates for the EUR–USD and JPY–USD markets around scheduled macroeconomic announcements. Using both the information shares approach and the common factor component weight approach for futures prices from the Chicago Mercantile Exchange (CME), as well as deal prices from spot trading on the Electronic Broking Services (EBS), we gauge how foreign exchange spot and futures markets respond to news surprises. The results show that the spot rates provide more price discovery than do the CME futures rates overall; however, the contribution of the futures rates to price discovery increases in the time surrounding macroeconomic announcement releases.     

The effectiveness of position limits: Evidence from the foreign exchange futures markets

This study considers the effects of the relative size of hedger and speculator open interests and the potential impact of implementing position limits on the price discovery process in both JPY–USD and EUR–USD futures markets. Hedging trading exerts a negative impact, regardless of its size, on price discovery in futures markets. Hedgers are less likely to be information motivated, so their trading uniformly delays the price discovery process. However, there is a positive and nonlinear impact of speculators’ trade size on price discovery, the contribution of which depends on the relative size of the speculative open interest. Contrary to conventional wisdom among regulators, speculative trading does not harm the market in terms of market efficiency; as long as the percentage of speculators’ open interest is below an endogenously determined threshold (approximately 20% for EUR–USD and 16.3% for JPY–USD), speculative trading even improves futures market efficiency.     

Combining mean reversion and momentum trading strategies in foreign exchange markets

The literature on equity markets documents the existence of mean reversion and momentum phenomena. Researchers in foreign exchange markets find that foreign exchange rates also display behaviors akin to momentum and mean reversion. This paper implements a trading strategy combining mean reversion and momentum in foreign exchange markets. The strategy was originally designed for equity markets, but it also generates abnormal returns when applied to uncovered interest parity deviations for five countries. I find that the pattern for the positions thus created in the foreign exchange markets is qualitatively similar to that found in the equity markets. Quantitatively, this strategy performs better in foreign exchange markets than in equity markets. Also, it outperforms traditional foreign exchange trading strategies, such as carry trades and moving average rules.     

Efficiency tests of foreign exchange markets for four Asian Countries

This paper uses the traditional variance ratio test of Lo and MacKinlay (1988, 1989), the non-parametric-based variance ratio test of Wright (2000) and the multiple-variance ratio test of Chow and Denning (1993), to re-examine the validity of the weak form efficient market hypothesis for foreign exchange markets in four floating-rate markets in neighboring Asian economies (Japan, South Korea, Taiwan and the Philippines). The results show that the random walk patterns of the exchange rate return series cannot be rejected, with the one exception of Taiwan, where inefficiency is shown to be most prominent. We therefore conclude that the foreign exchange markets of Japan, South Korea and the Philippines are weak form efficient, while the foreign exchange market of Taiwan is inefficient.     

Lessons from the evolution of foreign exchange trading strategies

The adaptive markets hypothesis posits that trading strategies evolve as traders adapt their behavior to changing circumstances. This paper studies the evolution of trading strategies for a hypothetical trader who chooses portfolios from foreign exchange (forex) technical rules in major and emerging markets, the carry trade, and US equities. The results show that a backtesting procedure to choose optimal portfolios improves upon the performance of nonadaptive rules. We also find that forex trading alone dramatically outperforms the S&P 500, with much larger Sharpe ratios over the whole sample, but there is little gain to coordinating forex and equity strategies, which explains why practitioners consider these tools separately. Forex trading returns dip significantly in the 1990s but recover by the end of the decade and have been markedly superior to an equity position since 1998. Overall, trading rule returns still exist in forex markets—with substantial stability in the types of rules—though they have migrated to emerging markets to a considerable degree.     

Foreign exchange risk pricing and equity market segmentation in Africa

This work is the first to investigate simultaneously the occurrence of unconditional currency risk pricing and equity market segmentation in Africa’s major stock markets. The multi-factor asset pricing theory provides the theoretical framework for our model. We find strong evidence suggesting that Africa’s equity markets are partially segmented. However, we find insufficient evidence to reject the hypothesis that foreign exchange risk is not unconditionally priced in Africa’s stock markets. This result is robust to alternative foreign exchange rate-adjusted return measures. These findings suggest that international investors can diversify into Africa’s equity markets without worrying about unconditional risks associated with foreign exchange rate fluctuations.     

Volatility clustering,leverage effects,and jump dynamics in the US and emerging Asian equity markets

This paper proposes asymmetric GARCH-Jump models that synthesize autoregressive jump intensities and volatility feedback in the jump component. Our results indicate that these models provide a better fit for the dynamics of the equity returns in the US and emerging Asian markets, irrespective whether the volatility feedback is generated through a common GARCH multiplier or a separate measure of volatility in the jump intensity function. We also find that they can capture several distinguishing features of the return dynamics in emerging markets, such as, more volatility persistence, less leverage effects, fatter tails, and greater contribution and variability of the jump component.     

Is the evidence for PPP reliable? A sustainability examination of the stationarity of real exchange rates

Some recent time series studies testing the stationarity of real exchange rates (RERs) produce conflicting results. Using nonlinear unit root tests and recursive analysis, this paper tests whether the evidence on the stationarity of RERs is sensitive to different numeraire currencies, different sample periods covering regional and global crises, and the inclusion of countries with different levels of economic or regional integration. The results indicate that evidence for a stationary RER could be substantially sensitive to sample period changes, but not so for the currencies of the countries involved in forming the euro area. We also find that financial crises have a notable impact on testing the stationarity of RERs, depending on the numeraire currency used. We discuss the policy implications of the findings.     

Evaluating foreign exchange market intervention: Self-selection,counterfactuals and average treatment effects

Estimating the effect of official foreign exchange market intervention is complicated by the fact that intervention at any point entails a “self-selection” choice made by the authorities and that no counterfactual is observed. To address these issues, we estimate the “counterfactual” exchange rate movement in the absence of intervention by introducing the method of propensity-score matching to estimate the “average treatment effect” (ATE) of intervention. To derive the propensity scores we estimate central bank intervention reaction functions. We estimate the ATE for daily official intervention in Japan over the January 1999–March 2004 period. This sample encompasses a remarkable variation in intervention frequencies as well as unprecedented frequent intervention towards the latter part of the period. We find that only sporadic and relatively infrequent intervention is effective.     

Investigating sources of unanticipated exposure in industry stock returns

This paper investigates the sources of both foreign exchange rate and interest rate exposure of industry level portfolios in the G7, decomposing exposure into cash flow and discount rate effects. Initial examination of the degree of exposure on industry returns produces results consistent with the prior literature: that there is little evidence of exchange rate exposure in most industries - the exchange rate exposure puzzle. However, rather than relying solely on the sensitivity of industry returns, we examine the cash flow sensitivity to foreign exchange exposure, of primary interest to firm managers. Critically, decomposing the exposure into cash flow and discount rate components unlocks the exact extent and nature of exposure. Our results show industries have significant cash flow and discount rate exposures. These exposures increase with the level of trade openness and the spread between permanent cash flow exposure and transitory discount rate exposure widens.     

International risk sharing is better than you think, or exchange rates are too smooth

Exchange rates depreciate by the difference between domestic and foreign marginal utility growth or discount factors. Exchange rates vary a lot, as much as 15% per year. However, equity premia imply that marginal utility growth varies much more, by at least 50% per year. Therefore, marginal utility growth must be highly correlated across countries: international risk sharing is better than you think. Conversely, if risks really are not shared internationally, exchange rates should vary more than they do: exchange rates are too smooth. We calculate an index of international risk sharing that formalizes this intuition. We treat carefully the realistic case of incomplete capital markets. We contrast our estimates with the poor risk sharing suggested by consumption data and home-bias portfolio calculations.     

Volatility transmission in emerging European foreign exchange markets

This paper studies the dynamics of volatility transmission between Central European (CE) currencies and the EUR/USD foreign exchange using model-free estimates of daily exchange rate volatility based on intraday data. We formulate a flexible yet parsimonious parametric model in which the daily realized volatility of a given exchange rate depends both on its own lags as well as on the lagged realized volatilities of the other exchange rates. We find evidence of statistically significant intra-regional volatility spillovers among the CE foreign exchange markets. With the exception of the Czech and, prior to the recent turbulent economic events, Polish currencies, we find no significant spillovers running from the EUR/USD to the CE foreign exchange markets. To measure the overall magnitude and evolution of volatility transmission over time, we construct a dynamic version of the Diebold–Yilmaz volatility spillover index and show that volatility spillovers tend to increase in periods characterized by market uncertainty.     

Forecasting foreign exchange rates using idiosyncratic volatility

Average idiosyncratic stock volatility forecasts the bilateral exchange rates of the US dollar against major foreign currencies in and out of sample. The US dollar tends to appreciate after an increase in US idiosyncratic volatility. Similarly, ceteris paribus, German and Japanese idiosyncratic volatilities positively and significantly correlate with future US dollar prices of the Deutsche mark and the Japanese yen, respectively. Our results suggest that exchange rates are predictable.     

Extreme coexceedances in new EU member states’ stock markets

We analyze the financial integration of the new European Union (EU) member states’ stock markets using the negative (positive) coexceedance variable that counts the number of large negative (large positive) returns on a given day across the countries. A similar analysis is performed for the old EU countries. We use a multinomial logit model to investigate how persistence, asset classes, and volatility are related to the coexceedance variables. We find that the effects differ (a) between negative and positive coexceedance variables (b) between old and new EU member states, and (c) before and after the EU enlargement in 2004, suggesting a closer connection of new EU stock markets to those in Western Europe.     

Intertemporal risk-return trade-off in foreign exchange rates

We investigate the intertemporal risk-return trade-off of foreign exchange (FX) rates for ten currencies quoted against the USD. For each currency, we use three risk measures simultaneously that pertain to that currency; its realized volatility, its realized skewness, and its value-at-risk. We apply monthly FX excess returns and risk measures calculated from daily observations. We find that there is a significant contemporaneous risk-return trade-off for the currencies under investigation. There is no evidence of noncontemporaneous risk-return trade-off. We pay special attention to the risk-return trade-off during the recent financial crisis.     

Estimating exchange rate responsiveness to shocks

The goal of this paper is to examine the importance of permanent and transitory shocks using a more efficient trend-cycle decomposition of the real exchange rate series. Our main contribution is that in measuring the impact of shocks, we not only impose common trend restrictions but also common cycle restrictions. We later confirm, through a post sample forecasting exercise, the efficiency gains from imposing common cycle restrictions. Our results indicate that permanent shocks are responsible for the bulk of the real exchange rate variations for Japan, Italy, Germany, France, and the UK vis-à-vis the US dollar over short horizons. For Canada, however, transitory shocks are dominant over the short horizon. In sum, while for Japan, France, and Italy, around 15% of the variation in real exchange rate is due to transitory shocks, for Canada, Germany and the UK, over 25% of the variations over the short horizon are due to transitory shocks. Thus, we claim that the role of transitory shocks should not be ignored.