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A collection of essays about foreign exchange risk and how to cope with it.
This volume grew out of a National Bureau of Economic Research conference on exchange rates held in Bellagio, Italy, in 1982. In it, the world's most respected international monetary economists discuss three significant new views on the economics of exchange rates - Rudiger Dornbusch's overshooting model, Jacob Frenkel's and Michael Mussa's asset market variants, and Pentti Kouri's current account/portfolio approach. Their papers test these views with evidence from empirical studies and analyze a number of exchange rate policies in use today, including those of the European Monetary System.
These seventeen essays provide an accessible and thorough reference for understanding the role of exchange rates in the international monetary system since 1973, when the rates were allowed to float. The essays analyze such issues as exchange rate movements, exchange risk premia, investor expectations of exchange rates and behavior of exchange rates in different systems. Frankel's sound empirical treatment of exchange rate questions shows that it is possible to produce work that is interesting from a purely intellectual viewpoint while contributing to practical knowledge of the real world of international economics and finance.The essays have been organized in a way that provides an introduction to the field of empirical international finance. Part I documents the steady reduction in barriers to international capital movement and leads logically to part II, which explains how exchange rates are determined. Both monetary and portfolio-based models are surveyed in part II, providing a clear transition to the topic of part III; the possible existence of an exchange risk premium. Part IV applies the tools discussed in earlier sections to explore various policy questions related to exchange rate expectations such as whether foreign exchange intervention matters and whether the European monetary system had become credible by 1991. Each part begins with a detailed introduction explaining not only the central issues of that section but also suggesting connections with other essays in the book.Jeffrey A. Frankel is Professor of Economics at the University of California, Berkeley.
This book describes and evaluates the literature on exchange rate economics. It provides a wide-ranging survey, with background on the history of international monetary regimes and the institutional characteristics of foreign exchange markets, an overview of the development of conceptual and empirical models of exchange rate behavior, and perspectives on the key issues that policymakers confront in deciding whether, and how, to try to stabilize exchange rates. The treatment of most topics is reasonably compact, with extensive references to the literature for those desiring to pursue individual topics further. The level of exposition is relatively easy to comprehend; the historical and institutional material (part I) and the discussion of policy issues (part III) contain no equations or technical notation, while the chapters on models of exchange rate behavior (part II) are written at a level intelligible to first-year graduate students or advanced undergraduates. The book will enlighten both students and policymakers, and should also serve as a valuable reference for many research economists.
Chapter 11 proposes using foreign exchange rate currency options with different strike prices and maturities to capture both currency risks and expectations, for helping understand currency return dynamics. We show that currency returns, which are notoriously difficult to model empirically, are well-explained by the term structures of forward premia and options-based measures of FX expectations and risk. Although this finding is to be expected, expectations and risk have been largely ignored in empirical exchange-rate modeling. Using daily options data for six major currency pairs, we first show that currency options-implied standard deviation, skewness, and kurtosis consistently improve the explanatory power of quarterly currency returns than a standardized UIP regression. We then show that adding term structure information of options-implied moments further improves the explanatory power. Our results highlight the importance of expectations and risk in explaining currency returns and suggest that this information may be particularly useful during a crisis period. Chapter 2 studies the term structure of currency risk using FX options data, and finds it able to explain the cross-sectional variation of currency excess returns. With the tool of a new FX risk index, "FCX", I look into currency risk term structure and measure its shape by level and slope. I consistently find that for currencies paired by US dollars, the term structure of currency risk is flat at a low level prior to the 2008 crisis, upward-sloping after the crisis and peaks at a high level with a prominently negative slope during the crisis. This work is believed to be new in the currency research field. I then use this information to build trading strategies, earning a profit by longing currencies with the highest level or slope and shorting ones with the lowest level or slope. The profit by sorting slope is significantly high and robust to the 2008 crisis period, with a low correlation to the Carry Trade return, suggesting extra information in risk than the interest rate. Next, I extract global risk factors by level and slope to help understand the currency excess return, a long-lasting puzzle. The global risk factor by level substantially improves the cross-sectional explanatory power in currency excess returns compared to Lustig et al. (2011). Furthermore, I show that there is certain high risk corresponding to a high level and low slope, and high interest rate currency earns returns co-varying negatively to this risk, implying that it is a risky asset and thus requires a high risk premium, which explains the Carry Trade return well. Chapter 32 explores the possible macroeconomic connection in currency markets through the channel of FX risk term structure. There is a consensus in the literature that exchange rates are empirically “disconnected” from fundamentals, but a possible theoretical insight is that macroeconomic volatility shocks induce time-varying risks in the exchange rates. This chapter empirically investigates the connection between macroeconomic fundamentals and time-varying currency risks captured by the FX risk term structure, following the main findings of chapters 1 and 2. This chapter use both a small dataset of directly observable, country-specific key macroeconomic and international variables implied by exchange rate structural modeling and a small number of macroeconomic factors constructed from a large dataset of 126 U.S. macroeconomic series by principal component analysis. We perform a VAR analysis to examine impulse responses of FX risk term structure to the shocks of macroeconomic events and find that production variables can generate a relatively consistent and systematic impact pattern, which suggests potential macroeconomic connection. We also perform a direct single regression, regressing the 126 macroeconomic series of eight different groups on the FX risk term structure and apply the group LASSO technique for variable selection. Variables among both macroeconomic fundamentals and financial series are commonly selected, which suggests that financial markets’ co-movements also exist besides potential macroeconomic connection.
These essays review recent advances in exchange rate analysis and new empirical analysis of the behavior of exchange rates and their effects on international trade and the U.S. economy. The first section deals with the determination of exchange rates and their alleged volatility and disequilibrium levels. The second section concerns the effects of flexible exchange rates on international trade, and the third treats the macroeconomic linkages between economies and international influences on the U.S. economy. ISBN 0-88410-948-8 : $39.95.