Discrete devaluations and multiple equilibria in a first generation model of currency crises

The first generation models of currency crises have often been criticized because they predict that, in the absence of very large triggering shocks, currency attacks should be predictable and lead to small devaluations. This paper shows that these features of first generation models are not robust to the inclusion of private information. In particular, this paper analyzes a generalization of the Krugman-Flood-Garber (KFG) model, which relaxes the assumption that all consumers are perfectly informed about the level of fundamentals. In this environment, the KFG equilibrium of zero devaluation is only one of many possible equilibria. In all the other equilibria, the lack of perfect information delays the attack on the currency past the point at which the shadow exchange rate equals the peg, giving rise to unpredictable and discrete devaluations.     

An event study of institutions and currency crises

We use event study methodology to examine the behavior of seven institutional variables eighteen months prior to and after a currency crisis. Our data on institutions include bureaucratic quality, corruption, ethnic tensions, external conflict, internal conflict, government stability, and law and order over the period 1984-2002. Our country coverage includes forty industrial, emerging market, and developing economies for various regions of the world. The graphical event study shows that there are many instances where institutions are weaker in periods before and after a currency crisis than during tranquil periods. The evidence is most compelling for government stability, law and order, bureaucratic quality, and corruption. We also test for differences in the mean values of institutional variables in turbulent periods around a crisis event and tranquil, non-crisis periods. Results from our tests generally complement evidence from the event study.     

Bounds and prices of currency cross-rate options

This paper derives the pricing bounds of a currency cross-rate option using the option prices of two related dollar rates via a copula theory and presents the analytical properties of the bounds under the Gaussian framework. Our option pricing bounds are useful, because (1) they are general in the sense that they do not rely on the distribution assumptions of the state variables or on the selection of the copula function; (2) they are portfolios of the dollar-rate options and hence are potential hedging instruments for cross-rate options; and (3) they can be applied to generate bounds on deltas. The empirical tests suggest that there are persistent and stable relationships between the market prices and the estimated bounds of the cross-rate options and that our option pricing bounds (obtained from the market prices of options on two dollar rates) and the historical correlation of two dollar rates are highly informative for explaining the prices of the cross-rate options. Moreover, the empirical results are consistent with the predictions of the analytical properties under the Gaussian framework and are robust in various aspects.     

The optimal currency basket under vertical trade

This paper explores the theory of optimal currency basket in a small open economy general equilibrium model with sticky prices. In contrast to existing literature, we focus on an economy with vertical trade, where the currencies in the basket may play different roles in invoicing trade flow. In a simple two-currency basket, one currency is used to invoice imported intermediate goods and is called “import currency”, while the other currency is used to invoice exported finished goods and is called “export currency”. We find that the optimal weights of the import currency and the export currency depends critically on the structure of vertical trade. Moreover, if a country decides to choose a single-currency peg, the choice of pegging currency also depends on how other competing economies respond to external exchange rate fluctuations.     

An equilibrium model of wealth distribution

I present an explicitly solved equilibrium model for the distribution of wealth and income in an incomplete-markets economy. I first propose a self-insurance model with an inter-temporally dependent preference [Uzawa, H. 1968. Time preference, the consumption function, and optimal asset holdings. In: Wolfe, J.N. (Ed.), Value, Capital, and Growth: Papers in Honour of Sir John Hicks. Edinburgh University Press, Edinburgh, pp. 485-504]. I then derive an analytical consumption rule which captures stochastic precautionary saving motive and generates stationary wealth accumulation. Finally, I provide a complete characterization for the equilibrium cross-sectional distribution of wealth and income in closed form by developing a recursive formulation for the moments of the distribution of wealth and income. Using this recursive formulation, I show that income persistence and the degree of wealth mean reversion are the main determinants of wealth-income correlation and relative dispersions of wealth to income, such as skewness and kurtosis ratios between wealth and income.     

The effect of exchange rate variability on US shareholder wealth

We examine the relationship between financial crisis exchange rate variability and equity return volatility for US multinationals. Empirical analysis of the major financial crises of the last decades reveals that stock return variability increases significantly in the aftermath of a crisis, even relative to the increase in stock return volatility for other firms belonging to the same industry and market capitalization class. In conjunction with this increase in total volatility, there is also an increase in stock market risk (β) for multinational firms. Moreover, trade and service oriented industries appear to be particularly sensitive to these changing exchange rate conditions.     

General equilibrium pricing of currency and currency options

This paper presents a consumption-based general equilibrium model for valuing foreign exchange contingent claims. The model identifies a novel economic mechanism by exploiting highly but imperfectly shared consumption disaster with variable intensities which are the concerns to the representative investor under recursive utility. When applied to the data, the model simultaneously replicates (i) the moderate option-implied volatilities; (ii) substantial variations in the risk-neutral skewness of currency returns; (iii) the uncovered interest rate parity puzzle; and (iv) the first two moments of carry trade returns. Furthermore, the model rationalizes salient features of the aggregate stock, government bonds, and equity index options.     

Currency bid-ask spread dynamics and the Asian crisis: Evidence across currency regimes

Using a sample of 21 emerging and developed country currencies, we evaluate the impact of the Asian crisis on bid-ask spreads. While the crisis had widespread and uniform volatility effects, the spread effects were not uniform across emerging and developed country currencies. For Asian emerging markets, spreads widened and spread volatility increased significantly during the crisis, while developed markets spreads narrowed and spread volatility decreased significantly. We investigate the impact of more flexible and less flexible exchange rate regimes on bid-ask spreads using panel data. In general, countries with tightly-managed regimes have significantly lower spreads than countries with more freely-floating regimes, while controlling for the influence of other factors such as volatility. Asian developing market spreads are higher than spreads of the other countries, again, after controlling for the influence of other factors.     

Pricing currency risk in the stock market: Evidence from Finland and Sweden 1970-2009

We investigate the role of currency risk on stock markets in two interlinked Nordic countries exhibiting a gradual move from fixed to floating exchange rates. We apply the Ding and Engle (2001) covariance stationary specification in a multivariate GARCH-M setup to test a conditional international asset pricing model. Using a sample period from 1970 to 2009, we find that the currency risk is priced in both stock markets, and that the price and the risk premium are lower after the floatation of the currencies, especially for Finland. We also find the cross-country exchange rate shock from Finland to affect the price of currency risk in Sweden, but not vice versa. Finally, we discuss some of the potential issues in applying multivariate GARCH-M specifications in tests of asset pricing models.     

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).     

A model of a currency shortage

Until the mid-19th century, shortages of currency were common. Moreover, a frequent policy response was a prohibition on the export of coins. We use a random matching model with indivisible money to explain a shortage and to judge the desirability of a prohibition on the export of coins. The model, although extreme in many regards, represents better than earlier models a demand for outside money and the problems that arise when that money is indivisible. It can also rationalize a prohibition on the export of money.     

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.     

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.     

Stochastic skew in currency options

We analyze the behavior of over-the-counter currency option prices across moneyness, maturity, and calendar time on two of the most actively traded currency pairs over the past eight years. We find that, on any given date, the conditional risk-neutral distribution of currency returns can show strong asymmetry. This asymmetry varies greatly over time and often switches signs. We develop and estimate a class of models that captures this stochastic skew behavior. Model estimation shows that our stochastic skew models significantly outperform traditional jump-diffusion stochastic volatility models both in sample and out of sample.     

Speculative attacks in a two-peg model

We present a two-country model of speculative attacks where the two countries peg their currency to the U.S. dollar and a continuum of investors can either attack or defend one or the two pegs. The main objective of the paper is to show how extending a single-peg model of speculative attacks with the presence of a second country pegging its currency changes the range of parameters for which a currency is attacked. The model suggests that the presence of another country fixing its exchange rate changes dramatically the range of parameters for which a currency is attacked or defended. For example, the model indicates that a peg with a relatively high probability of collapse could survive if the other peg is not very likely to be abandoned, so investors prefer instead to defend the second peg. Finally, under complete information, when the level of fundamentals in both economies is neither weak nor strong the stronger peg may collapse while the weaker peg may survive, so in principle any peg could be successfully attacked.     

Dynamic pricing and imperfect common knowledge

Introducing private information into the dynamic pricing decision of firms by adding an idiosyncratic component to marginal cost can help explain two stylised facts about price changes: Aggregate inflation responds gradually and with inertia to shocks at the same time as individual price changes can be large. The inertial behaviour of inflation is driven by privately informed firms strategically ‘herding’ on the public information contained in the observations of lagged aggregate variables. The model also matches the average duration between price changes found in the data and it nests the standard New-Keynesian Phillips Curve as a special case. To solve the model, the paper derives an algorithm for solving a class of dynamic models with higher order expectations.     

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.     

Foreign currency debt,financial crises and economic growth: A long-run view

Foreign currency debt is widely believed to increase risks of financial crisis, especially after being implicated as a cause of the East Asian crisis in the late 1990s. In this paper, we study the effects of foreign currency debt on currency and debt crises and its indirect effects on short-term growth and long-run output effects in both 1880–1913 and 1973–2003 for 45 countries. Greater ratios of foreign currency debt to total debt are associated with increased risks of currency and debt crises, although the strength of the association depends crucially on the size of a country's reserve base and its policy credibility. We found that financial crises, driven by exposure to foreign currency, resulted in significant permanent output losses. We estimate some implications of our findings for the risks posed by currently high levels of foreign currency liabilities in eastern Europe.     

Borrowing in foreign currency: Austrian households as carry traders

Household borrowing in a foreign currency is a widespread phenomenon in Austria. Thirteen percent of Austrian households report their housing loan to be denominated in foreign currency, mostly Swiss franc. Yet, despite its importance, peculiar character, and acute policy concerns, we know little about the attitudes and characteristics of the households involved in this type of carry trade. We analyze a uniquely detailed financial wealth survey of 2556 Austrian households to sketch a comprehensive profile of the attitudes and characteristics of the households involved. We employ both univariate tests and multivariate multinomial logit models. The survey data suggest that risk seeking, affluent, and married households are more likely to take a housing loan in a foreign currency. Financially literate or high-income households are more likely to take a housing loan in general. These findings partially assuage policy concerns about household default risk on foreign-currency housing loans or household retirement security.     

Forms of Foreign Investment Liberalization and Risk in Emerging Stock Markets

I examine the effect of different forms of foreign investment liberalization on risk in emerging equity markets, including international cross-listings and closed-end country funds, and in the domestic equity market as foreign investment restrictions are eliminated. I find that in Latin American markets volatility declines significantly with different forms of foreign investment liberalization, and in Asian markets volatility does not increase significantly. Volatility is driven by domestic factors in South America, but the transmission of volatility from the United States to Mexico increases after liberalization. The market risk exposure increases in Argentina after liberalization, in Chile with an index of American Depositary Receipts, and in Thailand with greater foreign ownership, reducing the diversification benefits of these markets.