A re-examination of exposure to exchange rate risk: The impact of earnings management and currency derivative usage

In an attempt to explain the weak evidence of priced exchange rate risk, we hypothesize that in addition to currency derivative usages, earnings management serves as another factor contributing to a reduction in exchange rate exposure. Our evidence reveals that earnings management activities, particularly those undertaken for the purpose of income smoothing, significantly reduce firm-specific exchange rate exposure, and that such role is particularly important if appropriate currency derivative instruments are limited. These results complement prior attempts to explain the puzzle of unpriced exchange rate risk. The investigation also highlights the importance of recognizing different managerial purposes behind discretionary accruals.     

Realizing the volatility impacts of sovereign credit ratings information on equity and currency markets: Evidence from the Asian Financial Crisis

We examine the effects of different types of sovereign rating announcements on realized stock and currency market volatilities and cross-asset correlations around periods of financial crises. Using intraday market data and sovereign ratings data for nine sample countries in the Asia-Pacific region over 1997–2001, we find that currency and stock markets react somewhat heterogeneously to various rating announcements and that stock markets are more responsive to rating news than currency markets. We find new evidence that ratings events have significant and asymmetric impacts on intraday market data and that national market attributes influence rating impacts during financial crises.     

On the sensitivity of the volume and volatility of bilateral trade flows to exchange rate uncertainty

We present an empirical investigation of the hypotheses that exchange rate uncertainty may have an impact on both the volume and variability of trade flows by considering a broad set of industrial countries' bilateral real trade flows over the period 1980–1998. Similar to the findings of earlier theoretical and empirical research, our first set of results shows that the impact of exchange rate uncertainty on trade flows is indeterminate. Our second set of results provides new and novel findings that exchange rate uncertainty has a consistent positive and significant effect on the volatility of bilateral trade flows, helping us better understand macroeconomic volatility.     

Exchange rate pass-through into import prices revisited: What drives it?

A large sample of developed and emerging economies is utilized to investigate import exchange rate pass-through. Panel models reveal that various economic aspects of the destination country can explain about one third of the total variation in pass-through elasticities and the remaining variation comes largely in the form of unobserved country-specific effects. Inflation, exchange rate volatility, openness and relative wealth play a clear role as drivers of emerging markets’ pass-through whereas the output gap and protectionism appear influential more generally. Nonlinearity regarding large-versus-small changes in the exchange rate is quite pervasive. Our evidence challenges the widely-held view that pass-through has been universally falling in developed markets and that it is higher for emerging markets. The economic drivers are shown to play a role as out-of-sample predictors of pass-through. The findings confirm pricing-to-market theories and have implications for the optimal conduct of monetary policy.     

The forward market in emerging currencies: Less biased than in major currencies

Many studies have replicated the finding that the forward rate is a biased predictor of the future change in the spot exchange rate. Usually the forward discount actually points in the wrong direction. But, at least until recently, those studies applied only to advanced economies and major currencies. We apply the same tests to a sample of 14 emerging market currencies. We find a smaller bias than for advanced country currencies. The coefficient is on average positive, i.e., the forward discount at least points in the right direction. It is never significantly less than zero. To us this suggests that a time-varying exchange risk premium may not be the explanation for traditional findings of bias. The reasoning is that emerging markets are probably riskier; yet we find that the bias in their forward rates is smaller. Emerging market currencies probably have more easily-identified trends of depreciation than currencies of advanced countries.     

Modeling exchange rate passthrough after large devaluations

Large devaluations are generally associated with large declines in real exchange rates. We develop a model which embodies two complementary forces that account for the large declines in the real exchange rate that occur in the aftermath of large devaluations. The first force is sticky nontradable-goods prices. The second force is the impact of real shocks that often accompany large devaluations. We argue that sticky nontradable goods prices generally play an important role in explaining post-devaluation movements in real exchange rates. However, real shocks can sometimes be primary drivers of real exchange-rate movements.     

A re-examination on dissecting the purchasing power parity puzzle

The purpose of this paper is to examine the source of a real exchange-rate adjustment based on the impulse-response function constructed from local projections when the true data-generating process (DGP) is unknown. This work extends the local-projection method proposed by Jordà [2005. Estimation and inference of impulse responses by local projections. American Economic Review 95, 161-182] to allow for variables that are I(1) and exhibit cointegration. Our paper shows that nominal exchange-rate adjustments dominate in the reversion toward PPP regardless of a nominal exchange-rate shock or a price shock. It is also shown that the half-life of real exchange rates is close to that of nominal exchange rates. Since these results are consistent with those of Cheung et al. [Cheung, Y.W., Lai, K.S., Bergman, M., 2004. Dissecting the PPP puzzle: the unconventional roles of nominal exchange rate and price adjustments. Journal of International Economics 64, 135-150], we therefore conclude that their main findings are robust to possible misspecifications in the true DGP.     

Risk-premia,carry-trade dynamics,and economic value of currency speculation

In this paper, we derive the dynamics and assess the economic value of currency speculation by formalizing the concept of a trader inaction range. We show that exchange rate returns comprise a time-varying risk-premium and that uncovered interest parity (UIP) holds in a speculative sense. The often-cited ‘forward bias puzzle’ originates from the omission of the risk-premium in standard UIP tests. Consistent with its popularity among market professionals, the carry-trade strategy can be rationalized as it systematically collects risk-premia, however, the economic value generated by bilateral carry-trades is limited.     

Trading the forward bias: Are there limits to speculation?

In this paper we investigate whether trading the forward bias allows for economically significant excess returns. We find that bias-trading strategies can be viewed as attractive investment opportunities per se, useful diversification devices, and promising portfolio extensions for active fund managers trying to beat their benchmarks. The empirical results, which also mirror the problems arising in attempts to explain the puzzle by risk-premia, are consistent with market evidence that the bias is traded in practice. Overall, our findings suggest that limits to speculation are unlikely to provide a (stand-alone) explanation for the persistence of the forward bias.     

Government finance in the wake of currency crises

We address three questions: (i) Can classical models be reconciled with the fact that many crises are marked by high rates of depreciation and small increases in seignorage revenue? (ii) What are the implications of different financing methods for post-crisis rates of inflation and depreciation? (iii) How do governments pay for the fiscal costs associated with currency crises? To study these questions we use a general equilibrium model in which prospective government deficits trigger a currency crisis. We then use our model in conjunction with fiscal data to interpret government financing in the wake of three recent currency crises: Korea (1997), Mexico (1994) and Turkey (2001).     

De facto exchange rate regimes and currency crises: Are pegged regimes with capital account liberalization really more prone to speculative attacks?

This paper empirically examines whether de facto exchange rate regimes affect the occurrence of currency crises in 84 countries over the 1980–2001 period by using the probit model. We employ the de facto classification of Reinhart and Rogoff (2004) that allows us to estimate the impact of relatively long-lived exchange rate regimes on currency crises with much greater precision. We find that pegged regimes significantly decrease the likelihood of currency crises compared with floating regimes. By using the combined data of exchange rate regimes and the existence of capital controls, we also find interesting evidence that pegged regimes with capital account liberalization significantly lower the likelihood of currency crises compared with other regimes. These results are robust to a wide variety of samples and models. From the standpoint of the macroeconomic policy trilemma, we can conjecture that pegged regimes with capital account liberalization are substantially less prone to speculative attacks because they can enhance greater credibility in their currencies by abandoning monetary policy autonomy.     

The relationship between investment and large exchange rate depreciations in dollarized economies

We use a simple financial friction in an economy with high degree of liability dollarization - and currency mismatch - to show that the negative balance-sheet effect of an exchange rate depreciation may be observable only if the magnitude of the depreciation is large enough. This result justifies the difficulty to find strong empirical evidence for balance-sheet effects and suggests the convenience of including a “large depreciation” term in empirical analyses. We review some of the related empirical literature and provide some new evidence of this large depreciation effect.     

Real exchange rate dynamics: The role of elastic labor supply

Empirical evidence suggests that the flexibility of labor supply is closely related to the dynamic adjustment of the real exchange rate. This paper investigates this relationship in a two-sector dependent economy model. While, the long-run equilibrium real exchange rate is independent of the elasticity of labor supply, our analysis confirms that the nature of the labor supply can be a crucially important determinant of its short-run dynamics. The extent to which this is so depends to some degree on the source of the underlying structural change that is driving the dynamics of the real exchange rate. Numerical simulations confirm that this mechanism may help explain the larger short-run volatility and more rapid convergence typically associated with developing countries having less flexible labor markets.     

Real exchange rate dynamics revisited: A case with financial market imperfections

In this paper, we investigate the relationship between real exchange rate dynamics and financial market imperfections. For this purpose, we first construct a New Open Economy Macroeconomics (NOEM) model that incorporates staggered loan contracts as a simple form of the financial market imperfections. Our model with such a financial market friction replicates persistent, volatile, and realistic hump-shaped responses of real exchange rates, which have been thought very difficult to materialize in standard NOEM models. Remarkably, these realistic responses can materialize even with both supply and demand shocks, such as cost-push, loan rate, and monetary policy shocks. This implies that the financial market development is a key element for understanding real exchange rate dynamics.     

Exchange risk and universal returns: A test of international arbitrage pricing theory

According to the international arbitrage pricing theory (IAPT) posited by Solnik (1983), currency movements affect assets' factor loadings and associated risk premiums. Based on a novel universal return decomposition, we propose an empirical model to test this proposition and perform tests using U.S. stock returns in the period 1975–2008. Our results confirm that currency movements significantly affect the market betas of a large proportion of stocks. Further cross-sectional tests indicate that currency movements affecting the market factor are significantly priced in stock returns. Based on these and other findings, we conclude that Solnik's IAPT is supported. An important implication of our findings is that exchange rate risk can broadly affect stock returns through both factor loading and residual factor channels.     

The international transmission of interest rate shocks: The Federal Reserve and emerging markets in Latin America and Asia

This paper analyzes the effects of changes in the U.S. Federal Reserve's Federal Funds rate on emerging countries' interest rates using high frequency (weekly) data. I also investigate how changes in the U.S. term structure affect short term rates' differentials. Other shocks include changes in the U.S. dollar–Euro exchange rate, changes in the international price of oil, risk ratings, and the degree of capital mobility. The results indicate that there is a strong and fairly rapid transmission of changes in the Federal Funds rate into interest rates in the Latin American countries in the sample. This effect is equally large in the Asian nations in the long run. The adjustment path is different across the two regions, however. Adjustment is very fast and cyclical in Latin America; it is gradual and slower in East Asia.