Overreaction and underreaction in the foreign exchange market

Research has documented overreaction and underreaction for stocks and stock market indices, but it has not yet analyzed these phenomena with regard to currency exchange rates. This paper examines exchange rate changes following extreme 1-day fluctuations for currencies in industrialized and emerging markets. In this study, the exchange rate is defined as the number of foreign currency units per US dollar. An overreaction phenomenon for currencies in emerging markets and an underreaction phenomenon for currencies in industrial markets are found. Each extreme 1-day currency fluctuation event is classified according to the type of underlying reason as described in the Wall Street Journal. Events for which no announcements (undefined events) were found are associated with a stronger tendency toward overreaction than those events for which an explanation was given (defined events). This suggests that investors overreact more when the source of the extreme fluctuation is largely unknown. The defined events are classified into two groups: economic events and political events. There is some evidence that political events are associated with a stronger tendency toward overreaction than economic events. These findings can be attributed to uncertainty. Political events (e.g., civil uprising) should be more difficult to assess than economic events (e.g., the release of an inflation report), and undefined events should be associated with the largest degree of uncertainty. Cross-sectional analysis is used to relate post-event exchange rate changes to the magnitude of the initial exchange rate change, leakage, day of the week effects, type of currency (from emerging or industrial market), and the type of announcement (economic, political, or undefined) that appeared in the Wall Street Journal. The cross-sectional analysis confirms that currencies in emerging markets experience stronger degrees of overreaction than those of industrial markets, even after controlling for potentially confounding factors. Moreover, it confirms that undefined events experience stronger degrees of overreaction than defined events, even when controlling for other factors.     

The crisis in the foreign exchange market

We provide an overview of the important events of the recent global financial crisis and their implications for exchange rates and market dynamics. Our goal is to catalogue all that was truly of major importance in this episode. We also construct a quantitative measure of crises that allows for a comparison of the current crisis to earlier events. In addition, we address whether one could have predicted costly events before they happened in a manner that would have allowed market participants to moderate their risk exposures and yield better returns from currency speculation.     

Information and volatility links in the foreign exchange market

We apply the trading model of Fleming et al (1998 ). to a number of currency markets. The model posits that two markets can have common volatility structures as a result of receiving common information and from cross‐hedging activity where a position in one currency is used to hedge risk in a position taken in another. Our results imply that the model is effective in identifying common information flows and volatility spillovers in the currency markets and that some of these effects are lost when simply examining raw correlations. A series of specification tests of the 21 bivariate systems that are examined provides support for the trading model in the foreign exchange context.     

Time-varying risk attitude and the foreign exchange market behavior

This paper presents a heterogeneous agents model of the foreign exchange market in which agents’ risk attitudes vary over time due to psychological factors emphasized in prospect theory. We find that psychological component and risk-profit elasticity play significant roles in exchange rate expectations formation and investment behavior. Although all agents show more risk-averse after the crisis, the extent to which their risk attitude responds to the crisis varies due to heterogeneous forecasting rules as well as the changes of trading environment and central bank intervention. Moreover, time-varying risk attitudes can help explain the forward premium puzzle. These findings have implications for the exchange rate expectation formation theories and foreign exchange market stability policies.     

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.     

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.     

Optimal informed trading in the foreign exchange market

We formulate a market microstructure model of exchange determination that we employ to investigate the impact of informed trading on exchange rates and on foreign exchange (FX) market conditions. With our formulation, we show how strategic informed agents influence exchange rates via both the portfolio-balance and information effects. We outline the connection which exists between the private value of information, market efficiency, liquidity and exchange rate volatility. Our model is also consistent with recent empirical research on the micro-structure of FX markets.     

Monitoring the foreign exchange rate benchmark fix

ABSTRACT

We develop a Manipulation Index (ManIx) that captures the potential manipulation intention of dealers during the World Markets/Reuters (WMR) benchmark (London Close) period at 4 pm London time through a unique algorithm and simulation. The application of this model (using a dataset with dealers’ identities) can identify banks that are prone to potential manipulative behavior. The results concerning the identified banks are validated by the regulatory investigations. Implementation of this algorithm allows regulators better direct their limited resources towards more targeted in-depth investigation.     

Emerging market exchange rate exposure

We estimate the exposure of emerging market companies to fluctuations in their domestic exchange rates. We use an instrumental-variable approach that identifies the total exposure of a company to exchange rate movements, yet abstracts from the influence of confounding macroeconomic shocks. In the sub-period of 1999–2002, we find that depreciations tend to have a negative impact on emerging market stock returns. In the sub-period of 2002–2006, this tendency has largely disappeared. Since we estimate the exchange rate exposure of firms from different countries with a common set of instruments, we can make coherent, cross-country comparisons of their determinants. We find that the impact of various measures of debt on exchange rate exposure, which is negative and significant in the early sub-period, becomes insignificant and even reverses sign in the recent sub-period.     

Price discovery in Taiwan's foreign exchange market

This paper investigates the dynamics of price adjustments and the price discovery roles of two markets on Taiwan's foreign exchange, TFI and CFE. Results from the multivariate threshold model indicate prices are integrated nonlinearly. The roles of price discovery are asymmetric, depending on the size and sign of the price discrepancies between the two markets. In the lower regime of discrepancies, each market employs information from its counterpart and reacts to each other with different adjustment speeds. When the discrepancy is in the upper regime, CFE's role of price discovery is characterized by its exogenous behavior within the error-correction process.     

Law enforcement and the black market exchange rate

This paper examines how a system of multiple exchange rates can give rise to unreported exports and imports and a black market for foreign exchange. Risk aversion rather than an assumed smuggling or detection technology generally guarantees the coexistence of legal and illegal trading. Evidence for Brazil suggests that enforcement of the exchange rate and trade regime is an important fundamental of the black market exchange rate that has so far invariably been left out of empirical work.     

Bid-ask bounce and speads in the foreign exchange futures market

This paper examines the intraday bid-ask bounce in Deutschemark and Japanese yen futures prices. The intraday Markovian bid-ask bounce process, which leads to a desirable equilibrium condition of reaching a bid or an ask transaction type with equal chances, is identified. A second-order Markov chain transition matrix model is used to derive a generalized estimator of bid-ask spreads in the foreign exchange futures market. It incorporates the conditional probabilities of a subsequent transaction being the same type as the current transaction's () and that of the next transaction being the same as the current type but different from the previous type (). The specification is {-Cov(P _t ,P _t+1 )/[(1–)(–)]}^1/2. The empirical results show that the average implied bid-ask spread is about $10, which is less than one tick's value of $12.50. It is also found that spreads are higher at the beginning and end of the trading day than the rest of the day, reflecting the uncertainty due to information flows and overnight inventory carrying costs, respectively.     

Technological bias at the exchange rate market

Prediction of exchange rates has been a topic for debate in economic literature since the late 1980s. The recent development of machine learning techniques has spurred a plethora of studies that further improves the prediction models for currency markets. This high-tech progress may create challenges for market efficiency along with information asymmetry and irrationality of decision-making. This technological bias emerges from the fact that recent innovative approaches have been used to solve trading tasks and to find the best trading strategies. This paper demonstrates that traders can leverage technological bias for financial market forecasting. Those traders who adapt faster to the changes in market innovations will get excess returns. To support this hypothesis we compare the performance of deep learning methods, shallow neural networks with baseline prediction methods and a random walk model using daily closing rate between three currency pairs: Euro and US Dollar (EUR/USD), British Pound and US Dollar (GBP/USD), and US Dollar and Japanese Yen (USD/JPY). The results demonstrate that deep learning achieves higher accuracy than alternate methods. The shallow neural network outperforms the random walk model, but cannot surpass ARIMA accuracy significantly. The paper discusses possible outcomes of the technological shift for financial market development and accounting conforming also to adaptive market hypothesis.     

Competitive entry and endogenous risk in the foreign exchange market

Recent evidence shows that higher trader participation increasesexchange rate volatility. To explore this linkage, we developa dynamic model of endogenous entry of traders subject to heterogenousexpectational errors. Entry of a marginal trader into the markethas two effects: it increases the capacity of the market toabsorb exogenous supply risk, and at the same time it adds noiseand endogenous trading risk. The competitive entry equilibriumis characterized by excessive market entry and excessively volatileprices. A positive tax on entrants can decrease trader participationand volatility while increasing market efficiency.     

Macroeconomic announcements and price discovery in the foreign exchange market

This study shows that the dominance of the overlapping trading hours of London and New York in the price discovery of the EUR/USD and USD/JPY markets only applies on days with U.S. announcements. Different from Cai et al. (2008) and Wang and Yang (2011), we highlight the informational advantage of local traders at the arrival of macroeconomic announcements in the local market, and find that macroeconomic announcements affect the pattern of price discovery across different markets, consistent with Chen and Gau (2010) and Jiang et al. (2012). We also examine changes in information shares before and after the announcement. A significant increase in price discovery before the announcement suggests the possibility of information leakage, while enhanced price discovery efficacy after the announcement suggests that prices gradually adjust to new information, not just immediately respond to the arrival of announcements.     

Behavioural asymmetries in the G7 foreign exchange market

This paper examines the exchange rate disconnect puzzle of Obstfeld and Rogoff (2000) from a behavioural perspective. It provides evidence on the existence of substantial asymmetries in the underlying loss preferences for the difference between the spot and forward nominal exchange rates between the G7 countries for one-week and four-week forecast horizons. We further perform forecast breakdown tests in forward markets during the Greek and the Portuguese sovereign debt crisis, and then re-estimate the loss preferences showing a mean-reverting transition from optimism to pessimism and vice versa. Finally, we attribute the evolution of preferences to economic fundamentals and risk indexes and find that together with significant endogenous dynamics, variables such as growth and deficit differentials, interest rate and legal risk assert some significant impact on asymmetry. This new set of information suggests that the puzzle could have its roots on an underlying asymmetric loss function that reflects variability in preferences over exchange rate movements due to a variety of episodes in economic fundamentals.     

Heterogeneous real-time trading strategies in the foreign exchange market

The foreign exchange (FX) market is worldwide, but the dealers differ in their geographical locations (time zones), working hours, time horizons, home currencies, access to information,transaction costs, and other institutional constraints. The variety of time horizones is large: from intra-day dealers, who close their positions every evening, to long-term investors and central banks. Depending on the constraints, the different market participats need different strategies to reach their goal, which is usually maximizing the profit, or rather a utility function including risk. Different intra-day trading strategies can be studied only if high-density data are available. Oslen & Associates (O & A) has collected and analysed large amounts of FX quotes by market makers around the clock (up to 5000 non-equally spaced prices per day for the German mark against US$). Based on these data, a set of real-time intra-day trading models has been developed. These models give explicit trading recommendations under realistic constraints. They are allowed to trade only during the opening hours of a market, depending on the time zone and local holidays. The models have been running real-time for more than three years, thus leading to an ex ante test. The test results, obtained with a risk-sensitive performance measure, are presented. All these trading models are profitable, but they differ in their risk behaviour and dealing frequency. If a certain profitable intra-day algorithm is tested with different working hours, its success can considerably change. A systematic study shows that the best choice of working hours is usually when the most important markets for the particular FX rate are active. All the results demonstrate that the assumption of a homogeneous 24-hour FX market with identical dealers, following an identical ‘rational expectation’, is far from reality. To explain the market dynamics, a heterogeneous model of the market with different types of dealers is more appropriate.     

Interest rates and risk premia in the stock market and in the foreign exchange market

This paper documents common empirical regularities in the foreign exchange market and in the US stock market. We find that increases in interest rates are associated with predictable increases in the volatility of returns in both markets, and that expected returns both in the stock market and in the foreign exchange market are negatively correlated with nominal interest rates.We show that not taking into account the time variation of second moments may seriously affect tests of asset pricing models. Using a numerical example based on the static capital asset pricing model, we are able to produce fluctuations in risk premia similar to those observed empirically. Finally we show that the overidentifying restrictions of the latent variable capital asset pricing model are not rejected when beats are assumed to be correlated with nominal interest rates.     

Discount rate changes,stock market returns,volatility, and trading volume: Evidence from intraday data and implications for market efficiency

We examine the effect of discount rate changes on stock market returns, volatility, and trading volume using intraday data. Equity returns generally respond negatively and significantly to the unexpected announcements; however, the effect of expected changes on equity returns is insignificant. Furthermore, our results indicate that equity prices respond to announcements within the trading period/hour after the information release. An indication of a return reversal is too small to cover the full transaction costs. Unexpected discount rate changes also contribute to higher market volatility although the volatility is short-lived. Similarly, unexpected changes in discount rates induce larger trading volume while expected changes do not. Abnormal trading volume occurs only in period t. Our results also support the notion that unexpected changes in the discount rates impact market returns irrespective of the Federal Reserve operating procedures.     

Conditional volatility persistence and volatility spillovers in the foreign exchange market

I investigate the magnitudes and determinants of volatility spillovers in the foreign exchange (FX) market, using realized measures of volatility and heterogeneous autoregressive (HAR) models. I confirm both meteor shower effects (i.e., inter-regional volatility spillovers) and heat wave effects (i.e., intra-regional volatility spillovers) in the FX market. Furthermore, I find that conditional volatility persistence is the dominant channel linking the changing market states of each region to future volatility and its spillovers. Market state variables contribute to more than half of the explanatory power in predicting conditional volatility persistence, with the model that calibrates volatility persistence and spillovers conditionally on market states performing statistically and economically better. The utilization of market state variables significantly extends our understanding of the economic mechanisms of volatility persistence and spillovers and sheds new light on econometric techniques for volatility modeling and forecasting.