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Specifically, this study investigates the relationship between changes in the real exchange rate and the pricing of risky financial assets in seventeen emerging and frontier markets of South & East Asia, Latin America, Africa and Eastern Europe. National investor groups are delineated by deviations from purchasing power parity, which causes them to evaluate differently the real returns from the same security. In a model with deviations from purchasing power parity, risky assets are priced based on their covariance with the world market and their covariance with changes in the real exchange rate. The study employs a conditional approach that allows for time varying risk premia in the presence of rational exchange rate risk hedging behavior by international investors. The results strongly support the multi-factor conditional international asset-pricing model with real exchange rate risk. The null hypothesis that exchange rate risk is not priced is rejected for all seventeen emerging markets. Implications are derived for optimal portfolio choices and currency risk hedging strategies for individual investors and firms seeking to diversify their portfolio holdings by investing in emerging market stocks and bonds.
This paper examines exchange rate exposure of country level stock returns in three emerging market economies: Korea, Taiwan and Thailand. The analysis is carried out at country level using stock indexes and trade-weighted exchange rates. Time-varying exchange rate exposure coefficients are obtained by estimating a Multivariate GARCH-M model with explicit focus on the non-orthogonality between exchange rate changes and market returns. Findings of the paper indicate that, although they are likely to vary over time, exchange rate exposure coefficients for Korea and Taiwan follow mean-reverting long-memory processes. However, the exposure coefficient for Thailand is found to be characterized by a non-stationary unit root process. The presence of mean-reverting exchange rate exposure coefficients has important implications for investment and hedging strategies.
Serven examines empirically the link between real exchange rate uncertainty and private investment in developing countries using a large cross country-time series data set. He builds a GARCH-based measure of real exchange rate volatility and finds that it has a strong negative impact on investment, after controlling for other standard investment determinants and taking into account their potential endogeneity. The impact of uncertainty is not uniform, however. There is some evidence of threshold effects, so that uncertainty only matters when it exceeds some critical level. In addition, the negative impact of real exchange rate uncertainty on investment is significantly larger in economies that are highly open and in those with less developed financial systems.
This paper presents a rule for foreign exchange interventions (FXI), designed to preserve financial stability in floating exchange rate arrangements. The FXI rule addresses a market failure: the absence of hedging solution for tail exchange rate risk in the market (i.e. high volatility). Market impairment or overshoot of exchange rate between two equilibria could generate high volatility and threaten financial stability due to unhedged exposure to exchange rate risk in the economy. The rule uses the concept of Value at Risk (VaR) to define FXI triggers. While it provides to the market a hedge against tail risk, the rule allows the exchange rate to smoothly adjust to new equilibria. In addition, the rule is budget neutral over the medium term, encourages a prudent risk management in the market, and is more resilient to speculative attacks than other rules, such as fixed-volatility rules. The empirical methodology is backtested on Banco Mexico’s FXIs data between 2008 and 2016.
We show that the response of firm-level investment to real exchange rate movements varies depending on the production structure of the economy. Firms in advanced economies and in emerging Asia increase investment when the domestic currency weakens, in line with the traditional Mundell-Fleming model. However, in other emerging market and developing economies, as well as some advanced economies with a low degree of structural economic complexity, corporate investment increases when the domestic currency strengthens. This result is consistent with Diaz Alejandro (1963)—in economies where capital goods are mostly imported, a stronger real exchange rate reduces investment costs for domestic firms.
Staff Discussion Notes showcase the latest policy-related analysis and research being developed by individual IMF staff and are published to elicit comment and to further debate. These papers are generally brief and written in nontechnical language, and so are aimed at a broad audience interested in economic policy issues. This Web-only series replaced Staff Position Notes in January 2011.
The book provides a comprehensive overview of the latest econometric methods for studying the dynamics of macroeconomic and financial time series. It examines alternative methodological approaches and concepts, including quantile spectra and co-spectra, and explores topics such as non-linear and non-stationary behavior, stochastic volatility models, and the econometrics of commodity markets and globalization. Furthermore, it demonstrates the application of recent techniques in various fields: in the frequency domain, in the analysis of persistent dynamics, in the estimation of state space models and new classes of volatility models. The book is divided into two parts: The first part applies econometrics to the field of macroeconomics, discussing trend/cycle decomposition, growth analysis, monetary policy and international trade. The second part applies econometrics to a wide range of topics in financial economics, including price dynamics in equity, commodity and foreign exchange markets and portfolio analysis. The book is essential reading for scholars, students, and practitioners in government and financial institutions interested in applying recent econometric time series methods to financial and economic data.
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This paper provides new evidence on the pricing of exchange risk in global stock markets. We conduct empirical tests in a conditional setting with a multivariate GARCH-in-Mean specification and time-varying prices of risk for the US and nine emerging markets to determine whether exchange risk is priced under alternative model specifications and exchange rate measures. Since inflation rates in emerging markets are high and volatile, we argue that the use of real exchange rates offer a better proxy for risk stemming from purchasing power parity deviations. In addition to using real exchange rates, the empirical model allows for partial integration by including a time-varying price of local risk. Our main results support the hypothesis of significant exchange risk premia related to both emerging and developed markets. The price of exchange risk is also significantly time-varying consistent with previous evidence for major developed markets. The empirical evidence also suggests that there is variation across countries and over time in the relative importance of exchange risk premia. However, currency risk remains an important global risk factor even after accounting for local risk.
Large fundamental imbalances persist in the global economy, with potential exchange rate implications. This paper assesses whether exchange rate risk is priced across G-7 stock markets. Given the multitude of hedging instruments available, theory suggests that stock market investors should not be compensated for currency risk. However, data covering 33 industry portfolios across seven major stock markets suggest that not only is exchange rate risk priced in many markets, but that it is time-varying and sensitive to currency-specific shocks. With stock market investors typically exhibiting "home bias," this suggests that investors are using equity asset proxies to hedge the exchange rate risks to consumption.