Going multinational under exchange rate uncertainty

We analyze a model where an exporting firm competes a la Cournot in a foreign market. The firm faces exchange rate uncertainty and has the option to invest abroad. The paper contributes four results. First, real option pricing techniques are used to derive the optimal timing rule of the investment and the price of the firm and foreign competitors. Second, the sunk cost of entry into the foreign market introduces hysteresis in direct investment flows. We find that the degree of hysteresis grows with the number of firms in the industry. Third, we determine the conditions under which dumping may appear and the role of FDI in precluding this type of dumping. Fourth, tariffs have the well known FDI-inducing effect, more so in less competitive markets, and are more effective at deterring delocation. Furthermore, a tariff might have the effect of triggering dumping.     

Banking deregulation and innovation

We document empirical support for a key micro-level channel—innovation by young, private firms—through which financial sector deregulation affects economic growth. We find that intrastate banking deregulation, which increased the local market power of banks, decreased the level and risk of innovation by young, private firms. In contrast, interstate banking deregulation, which decreased the local market power of banks, increased the level and risk of innovation by young, private firms. These contrasting effects on innovation also translated into contrasting effects on economic growth. Our study suggests that the nature of financial sector deregulation crucially affects its potential benefits to the real economy.     

Debt,investment, and product market competition: A note on the limited liability effect

This paper extends a model by Brander and Lewis [Brander, J., Lewis, T., 1986. Oligopoly and financial structure: The limited liability effect. American Economic Review 76, 956–970] on the relationship between capital structure, investment and product market competition based on the limited liability effect of debt. Empirical papers (see for example Campello [Campello, M., 2003. Capital structure and product markets interactions: Evidence from business cycles. Journal of Financial Economics 68, 353–378], and Chevalier [Chevalier, J., 1995a. Capital structure and product market competition: Empirical evidence from the supermarket industry. American Economic Review 85, 415–435; Chevalier, J., 1995b. Do LBO supermarkets charge more? An empirical analysis of the effect of LBOs on supermarket pricing. Journal of Finance 50, 1095–1112]) generally reject the limited liability theories in favor of the predatory theories because leverage leads to less investment and weaker product market competition. This paper shows that when firms also have an investment choice, leverage can lead to weaker product market competition in a limited liability model. In addition, non-zero leverage is still optimal within this model based solely on the limited liability effect. In predatory models debt is motivated by issues outside of product market concerns, for example to solve an agency problem. Finally, this model is also consistent with the investment decisions documented empirically.     

Pegged Exchange Rate Regimes—A Trap?

We analyze the role of an exchange rate peg as a commitment mechanism to achieve inflation stability when multiple equilibria are possible. We show that there are ex ante large gains from choosing a more conservative regime not only in order to mitigate inflation bias from time inconsistency but also to avoid high inflation equilibria. In these circumstances, using a pegged exchange rate as an anti-inflation commitment device can create a \"trap\" whereby the regime initially confers gains in anti-inflation credibility but ultimately results in an exit occasioned by a big enough adverse real shock that creates large welfare losses to the economy.     

Interest rate interactions in the classical gold standard, 1880-1914: was there any monetary independence?

This paper examines an hypothesis of Svensson (1994) (Journal of Monetary Economics 33, 157-199) that a credible target zone can confer on a country a degree of independence in the operation of its monetary policy, even when exchange rates are fixed. We test this hypothesis for the Classical gold standard using a newly created monthly data base for the period 1880-1913. Building on the recently noted finding that the Classical gold standard represented a credible, well-behaved, target zone system we propose a number of ways of testing the Svensson’ model. Our main finding is that the Classical gold standard did indeed confer some independence in the operation of monetary policy for participating countries. This would seem to have an important bearing on the kind of institutional framework required for a modern day target zone to function effectively and, in particular, to weather speculative attacks.     

Forecasting Emerging Market Exchange Rates from Foreign Equity Options

The use of derivatives to infer future exchange rates has long been a subject of interest in the international finance literature. With the recent currency crises in Mexico, Southeast Asia, and Brazil, work on exchange rate expectations in emerging markets is of particular interest. For some emerging markets, foreign equity options are the only liquid exchange‐traded derivatives with currency information embedded in their prices. Given that emerging markets sometimes undergo currency realignment with discrete jumps in their exchange rate, estimation of risk‐neutral probability density functions from foreign equity option data provides valuable evidence concerning market expectations. To illustrate the use of foreign equity options in estimating market beliefs, we consider Telmex options around the 1994 peso devaluation and find evidence that markets anticipated the change in the Mexican government's foreign exchange policy.     

Are elite universities losing their competitive edge?

We study the location-specific component of research productivity for economics and finance faculty over the last three decades. We find that there was a positive effect of being affiliated with a top 25 university in the 1970s; this effect weakened in the 1980s and disappeared in the 1990s. The decline in elite university fixed effect is due to the reduced importance of physical access to productive research colleagues, which in turn seems due to innovations in communication technology. One implication is that knowledge-based organizations should find it more difficult to capture rents vis-à-vis workers. We find that faculty salaries increased the most where the estimated spillover dropped the most. Despite the loss in local spillovers, elite universities still enjoy an edge in average productivity because of agglomeration of top researchers in prestigious institutions with high long-term research reputations.     

Chronicle of currency collapses: Re examining the effects on output

The impact of currency collapses (i.e. large nominal depreciations or devaluations) on real output remains unsettled in the empirical macroeconomic literature. This paper provides new empirical evidence on this relationship using a dataset for 108 emerging and developing economies over the period 1960–2006. We provide estimates of how these episodes affect growth and output trend. Our main finding is that currency collapses are associated with a permanent output loss relative to trend, which is estimated to range between 2% and 6% of GDP. However, we show that such losses tend to materialize before the drop in the value of the currency, which suggests that the costs of a currency crash largely stem from the factors leading to it. Taken on its own (i.e. ceteris paribus), we find that currency collapses tend to have a positive effect on output. More generally, we also find that the likelihood of a positive growth rate in the year of the collapse is over two times more likely than a contraction, and that positive growth rates in the years that follow such episodes are the norm. Finally, we show that the persistence of the crash matters, i.e. one-time events induce exchange rate and output dynamics that differ from consecutive episodes.     

Exchange rate dynamics under state-contingent stochastic process switching

This paper offers a closed-form solution of a process switching problem, i.e., switching the exchange rate regime from free-floating to a completely fixed one. An example of such regime change is the adoption of the Euro. In contrast to previous studies on the subject, this paper analyzes a specific case when foreign exchange market participants consider both the Euro locking rate and locking date as uncertain. Preceding the locking, the exchange rate is determined by three factors: fundamental, market expectations for the Euro locking rate, and date. The model is used to examine the conditions under which the exchange rate volatility is mitigated by the prospect of locking.     

Emerging markets and heavy tails

Emerging countries are held to be subject to more frequent and more pronounced external and internal shocks than their developed counter-parts. This suggests that key variables pertaining to their markets, including their exchange rates, will be marked by greater likelihood of extreme observations and large fluctuations. We focus on the hypothesis that compared to developed country exchange rates, emerging country exchange rates will be more pronouncedly heavy-tailed. We find support for the hypothesis using recently proposed robust tail index estimation methods which, in particular, perform well under heavy-tailed dependent GARCH processes that are often used for modeling exchange rates. According to the estimation results reported in the paper, variances may be infinite for several emerging country exchange rates. Tail index values ζ = p ∈ (2.6, 2.8) appear to be at the dividing boundary between the two sets of countries: while the moments of order p ∈ (2.6, 2.8) are finite for most of the developed country exchange rates, they may be (or are) infinite for most of the emerging country exchange rates. We also study the impact of the on-going financial and economic crisis, and find that heavy-tailedness properties of most exchange rates did not change significantly with the onset of the crisis. At the same time, some foreign exchange markets have experienced structural changes in their heavy-tailedness properties during the crisis.     

The expectation hypothesis of the term structure of very short-term rates: Statistical tests and economic value

This paper reexamines the validity of the expectation hypothesis (EH) of the term structure of US repo rates ranging in maturity from overnight to 3 months. We extend the work of Longstaff [2000b. The term structure of very short term rates: new evidence for the expectations hypothesis. Journal of Financial Economics 58, 397–415] in two directions: (1) we implement statistical tests designed to increase test power in this context; (2) more important, we assess the economic value of departures from the EH based on criteria of profitability and economic significance in the context of a simple trading strategy. The EH is rejected throughout the term structure examined on the basis of the statistical tests. However, the results of our economic analysis are favorable to the EH, suggesting that the statistical rejections of the EH in the repo market are economically insignificant.     

Speculative capital and currency carry trades

In this paper, we study a two-country general equilibrium model with partially segmented financial markets, where hedge funds emerge endogenously. Empirically, we show that the hedge fund investment strategy predicted by our model, which we call the “risk-adjusted carry trade” strategy, explains more than 16% of the overall hedge fund index returns and more than 33% of the fixed income arbitrage sub-index returns. The flow of new money to hedge funds affects market interest rates, exchange rates, and both the hedge funds’ contemporaneous and expected future returns as predicted by the model.     

Persistence in law of one price deviations: Evidence from micro-data

Using an extensive micro-price panel, we find a positive cross-sectional relationship between LOP persistence and the distribution margin, which we measure using sectoral U.S. data, as suggested by the classical dichotomy. The median level of persistence (across goods) is low, and there is no evidence of a border effect: the half-life of a deviation is about 19 months across OECD cities and just 1 month lower across cities in the U.S. Aggregating our micro-data using a variety of weighting methods shows PPP persistence to be in the range of 1-2 years, over the 1990-2005 period. These results challenge three widely held views: (i) the classical dichotomy is irrelevant; (ii) high persistence is a robust feature of aggregate real exchange rates; and (iii) border crossings necessarily generate greater real exchange rate persistence.     

Smiles all around: FX joint calibration in a multi-Heston model

We introduce a novel multi-factor Heston-based stochastic volatility model, which is able to reproduce consistently typical multi-dimensional FX vanilla markets, while retaining the (semi)-analytical tractability typical of affine models and relying on a reasonable number of parameters. A successful joint calibration to real market data is presented together with various in- and out-of-sample calibration exercises to highlight the robustness of the parameters estimation. The proposed model preserves the natural inversion and triangulation symmetries of FX spot rates and its functional form, irrespective of choice of the risk-free currency. That is, all currencies are treated in the same way.