Handbook of Exchange Rates

JESSICA JAMES, PhD, is a Managing Director and Co-Head of the Quantitative Solution Team at Commerzbank in London, where she is responsible for FX client risk advisory. She has published on the topics of credit derivatives and total return swaps and is the coauthor of Interest Rate Modelling (Wiley).IAN W. MARSH, PhD, is Professor of Finance in the Cass Business School at City University London. Dr. Marsh has extensive consulting experience with companies including JPMorgan Chase, Morley Fund Managment, and the Royal Bank of Scotland. He currently focuses his research on credit risk transfer markets and the foreign exchange market.LUCIO SARNO, PhD, is Associate Dean, Head of Faculty, and Professor of Finance in the Cass Business School at City University London. Dr. Sarno has extensive industry experience in consulting and trading foreign exchange for several major asset management companies and has contributed to policy, training, and research for the International Monetary Fund, the European Central Bank, and the World Bank.

• Preface xxiiiContributors xxviipart one Overview1 Foreign Exchange Market Structure, Players, and Evolution 31.1 Introduction, 31.2 Geography and Composition of Currency Trading, 41.2.1 Which Currencies are Traded? 61.2.2 What Instruments are Traded? 91.2.3 How is Trading Regulated? 91.3 Players and Information in FX Markets, 111.3.1 Who Needs Liquidity? 121.3.2 Who Provides Liquidity? 151.3.3 Asymmetric Information and Exchange Rate Determination, 191.4 Electronic Trading Revolution in FX Markets, 211.4.1 The Telephone Era, 221.4.2 The Rise of the Computer, 221.4.3 Recent Developments in Electronic Trading, 301.5 Survey of Multibank FX Platforms, 351.6 Summary, 38Glossary, 39Acknowledgments, 41References, 422 Macro Approaches to Foreign Exchange Determination 452.1 Introduction, 452.2 Models of the Nominal Exchange Rate, 462.2.1 The Monetary Model, 462.2.2 Portfolio Balance Models, 492.2.3 Empirical Evidence, 512.3 Real Models of the Real Exchange Rate, 542.3.1 Purchasing Power Parity, 552.3.2 Balassa–Samuelson and Productivity-Based Models, 562.3.3 Two-Good Models, 592.4 New Directions in Exchange-Rate Modeling, 602.4.1 Taking Reaction Functions Seriously, 602.4.2 The Impact of Financial Globalization, 632.4.3 The Risk Premium and Order Flow, 642.5 Conclusions, 65Acknowledgments, 65References, 663 Micro Approaches to Foreign Exchange Determination 733.1 Introduction, 733.2 Perspectives on Spot-Rate Dynamics, 743.2.1 Decomposition of Depreciation Rates, 743.2.2 Macro- and Microperspectives, 773.3 Currency Trading Models and their Implications, 803.3.1 The Portfolio Shifts Model, 813.3.2 Empirical Implications, 883.4 Exchange Rates, Order Flows, and the Macro Economy, 953.4.1 A Micro-Based Macro model, 963.4.2 Empirical Implications, 1003.5 Conclusion, 105Appendix, 1053.6 Acknowledgment, 108References, 1084 The Exchange Rate in a Behavioral Finance Framework 1114.1 Introduction, 1114.1.1 Mainstream Exchange Rate Models, 1114.1.2 Away from the Mainstream, 1134.2 Exchange Rate Puzzles, 1144.2.1 Disconnect Puzzle and Excess Volatility Puzzle, 1144.2.2 Unit Root Property, 1154.2.3 Volatility Clustering, 1184.2.4 Fat-Tailed Distributed Exchange Rate Returns, 1194.3 A Prototype Behavioral Model of the Foreign Exchange Market, 1224.4 Conclusion, 127References, 1295 The Evolution of Exchange Rate Regimes and Some Future Perspectives 1335.1 Introduction, 1335.2 A Brief History of Currency Regimes, 1355.3 Performance of the Laisser-Faire Exchange Rate System, 1973–2010, 1385.3.1 Market Discipline, 1395.3.2 Economic Policy Coordination, 1405.3.3 Integration of Emerging Market Countries into the Global Economy, 1405.4 Trends in Currency Use, 1415.4.1 Global Imbalances and the Financial Crisis of 2007–2009, 1435.5 Prospects for the Future, 1445.5.1 The Current System, 1445.5.2 Toward a more Managed International Monetary System? 1465.5.3 How and When Will Reform Occur? 1505.5.4 A Global Nominal Anchor? 1515.6 Concluding Comments, 153Appendix A: A Formal Test of Hollowing Out, 154References, 156part two Exchange Rate Models and Methods6 Purchasing Power Parity in Economic History 1616.1 Introduction, 1616.2 Categorization of Purchasing-Power-Parity Theories, 1626.3 Historical Application of PPP: Premodern Periods, 1636.3.1 Ancient Period, 1636.3.2 Medieval Period, 1646.3.3 Sixteenth-Century Spain, 1656.4 Techniques of Testing PPP Theory in Economic-History Literature, 1656.4.1 Comparative-Static Computation, 1656.4.2 Regression Analysis, 1656.4.3 Testing for Causality, 1656.4.4 Nonstationarity and Spurious Regression, 1666.4.5 Testing for Stationarity, 1676.4.6 Cointegration Analysis, 1676.5 Price Variable in PPP Computations, 1686.6 Modern Period: Testing of PPP, 1696.6.1 Early North America, 1696.6.2 Bullionist Periods, 1706.6.3 Floating Rates—Second-Half of Nineteenth Century, 1716.6.4 Classic Metallic Standards, 1726.6.5 World War I, 1726.6.6 Floating Rates—1920s, 1736.6.7 1930s, 1756.6.8 Interwar Period, 1756.6.9 Spain—Long Term, 1766.6.10 Guatemala—Long Term, 1766.7 Analysis of U.S. Return to Gold Standard in 1879, 1776.8 Establishment and Assessment of a Fixed Exchange Rate in Interwar Period, 1776.8.1 United Kingdom, 1776.8.2 France, 1796.9 Conclusions, 180References, 1817 Purchasing Power Parity in Tradable Goods 1897.1 Introduction, 1897.2 The LOP and Price Indices, 1907.3 Empirical Evidence on the LOP, 1947.3.1 Early Tests of the LOP, 1947.3.2 The Border Effect, 1947.3.3 Barriers to Arbitrage and Nonlinearities, 1957.3.4 The Tradable Versus Nontradable Goods Dichotomy, 1987.3.5 The Aggregation Bias and Micro Price Studies, 1997.4 Purchasing Power Parity, 2007.4.1 Transitory and Structural Disparities from Parity, 2037.5 Aggregating from the LOP to PPP: What Can We Infer? 2057.5.1 An Eyeball Analysis of PPP, 2077.6 Conclusion and Implications, 213Appendix: TAR Modeling, 214Acknowledgments, 215References, 2158 Statistical and Economic Methods for Evaluating Exchange Rate Predictability 2218.1 Introduction, 2218.2 Models for Exchange Rate Predictability, 2248.2.1 A Present Value Model for Exchange Rates, 2248.2.2 Predictive Regressions, 2268.3 Statistical Evaluation of Exchange Rate Predictability, 2288.4 Economic Evaluation of Exchange Rate Predictability, 2318.4.1 The Dynamic FX Strategy, 2318.4.2 Mean-Variance Dynamic Asset Allocation, 2318.4.3 Performance Measures, 2328.4.4 Transaction Costs, 2348.5 Combined Forecasts, 2358.6 Empirical Results, 2378.6.1 Data on Exchange Rates and Economic Fundamentals, 2378.6.2 Predictive Regressions, 2428.6.3 Statistical Evaluation, 2448.6.4 Economic Evaluation, 2498.7 Conclusion, 256Appendix A: The Bootstrap Algorithm, 259Acknowledgments, 260References, 2609 When Are Pooled Panel-Data Regression Forecasts of Exchange Rates More Accurate than the Time-Series Regression Forecasts? 2659.1 Introduction, 2659.2 Panel Data Exchange Rate Determination Studies, 2679.3 Asymptotic Consequences of Pooling, 2689.3.1 Predictive Regression Estimated on Full Sample, 2689.3.2 Out-of-Sample Prediction, 2719.4 Monte Carlo Study, 2729.5 An Illustration with Data, 2759.6 Conclusions, 278References, 27910 Carry Trades and Risk 28310.1 Introduction, 28310.2 The Carry Trade: Basic Facts, 28510.2.1 What is a Carry Trade? 28510.2.2 Measuring the Returns to the Carry Trade, 28610.3 Pricing the Returns to the Carry Trade, 29010.4 Empirical Findings, 29310.4.1 Traditional Risk Factors, 29310.4.2 Factors Derived from Currency Returns, 29910.5 Time-Varying Risk and Rare Events, 30810.6 Conclusion, 311Acknowledgments, 311References, 31111 Currency Fair Value Models 31311.1 Introduction, 31311.2 Models/Taxonomy, 31511.2.1 ‘‘Adjusted PPP’’: Harrod-Balassa-Samuelson and Penn Effects, 31511.2.2 The Behavioral Equilibrium Exchange Rate Family of Models, 31611.2.3 The Underlying Balance (UB) Approach, 32011.2.4 External Sustainability (ES) Approach, 32411.2.5 The Natural Real Exchange Rate (NATREX), 32511.2.6 The Indirect Fair Value (IFV), 32511.3 Implementation Choices and Model Characteristics, 32811.3.1 Horizon/Frequency, 32911.3.2 Direct Econometric Estimation Versus ‘‘Methods of Calculation’’, 33111.3.3 Treatment of External Imbalances , 33211.3.4 Real Versus Nominal Exchange Rates, 33311.3.5 Bilateral Versus Effective Exchange Rate, 33311.3.6 Time Series Versus Cross Section or Panel, 33611.3.7 Model Maintenance, 33611.4 Conclusion, 337Acknowledgments, 338References, 33912 Technical Analysis in the Foreign Exchange Market 34312.1 Introduction, 34312.2 The Practice of Technical Analysis, 34512.2.1 The Philosophy of Technical Analysis, 34512.2.2 Types of Technical Analysis, 34612.3 Studies of Technical Analysis in the Foreign Exchange Market, 35012.3.1 Why Study Technical Analysis? 35012.3.2 Survey Evidence on the Practice of Technical Analysis, 35012.3.3 Computing Signals and Returns, 35112.3.4 Early Studies: Skepticism before the Tide Turns, 35312.3.5 Pattern Recognition, Intraday Data, and Other Exchange Rates, 35312.4 Explaining The Success of Technical Analysis, 35512.4.1 Data Snooping, Publication Bias, and Data Mining, 35512.4.2 Temporal Variation in Trading Rule Returns, 35712.4.3 Do Technical Trading Returns Compensate Investors for Bearing Risk? 35912.4.4 Does Foreign Exchange Intervention Create Trading Rule Profits? 36112.4.5 Do Cognitive Biases Create Trading Rule Profits? 36312.4.6 Do Markets Adapt to Arbitrage Away Trading Rule Profits? 36512.5 The Future of Research on Technical Analysis, 36612.6 Conclusion, 367Acknowledgments, 368References, 36813 Modeling Exchange Rates with Incomplete Information 37513.1 Introduction, 37513.2 Basic Monetary Model, 37613.3 Information Heterogeneity, 37913.4 Model Uncertainty, 38113.5 Infrequent Decision Making, 38513.6 Conclusion, 388Acknowledgments, 388References, 38914 Exchange Rates in a Stochastic Discount Factor Framework 39114.1 Introduction, 39114.2 Exchange Rates and Stochastic Discount Factors, 39214.2.1 Stochastic Discount Factors, 39214.2.2 Real Exchange Rates and Currency Risk Premia, 39514.3 Empirical Evidence, 39814.3.1 From UIP Regressions to Currency Portfolios, 39814.3.2 Annual Currency Excess Returns and Aggregate Risk, 39914.3.3 Monthly Currency Excess Returns, 40314.3.4 Implications for Stochastic Discount Factors, 40314.3.5 Predictability of Currency Excess Returns, 40514.4 Models, 40714.4.1 Habits, 40714.4.2 Long-Run Risk, 41114.4.3 Disaster Risk, 41414.5 Conclusion, 417References, 41715 Volatility and Correlation Timing in Active Currency Management 42115.1 Introduction, 42115.2 Dynamic Models for Volatility and Correlation, 42415.2.1 The Set of Multivariate Models, 42515.2.2 The Set of Univariate Models for Volatility Timing, 42715.2.3 Pairwise Model Comparisons, 42715.2.4 Estimation and Forecasting, 42715.3 The Economic Value of Volatility and Correlation Timing, 42815.3.1 The Dynamic Strategy, 42815.3.2 Dynamic Asset Allocation with CRRA Utility, 42815.3.3 Performance Measures, 42915.3.4 Transaction Costs, 43015.4 Parameter Uncertainty in Bayesian Asset Allocation, 43015.5 Model Uncertainty, 43115.5.1 The BMA Strategy, 43215.5.2 The BMW Strategy, 43215.6 Empirical Results, 43215.6.1 Data and Descriptive Statistics, 43215.6.2 Bayesian Estimation, 43315.6.3 Evaluating Volatility and Correlation Timing, 43415.7 Conclusion, 440Appendix A: Univariate Models for Volatility Timing, 442Appendix B: Parameter Uncertainty and the Predictive Density, 443Acknowledgments, 444References, 444part three FX Markets and Products16 Active Currency Management Part I: Is There a Premium for Currency Investing (Beta) 45316.1 Introduction, 45316.2 Beta in the Foreign Exchange Markets, 45516.2.1 Understanding the FX Carry Trade, 45516.2.2 FX Carry as a Broader Strategy, 45616.2.3 FX Trend-Based Strategies, 45816.2.4 Value-Based Strategies Within FX, 46016.2.5 USD Directional Trade, 46116.2.6 Correlation between these FX Strategies and Other Forms of Beta, 46216.2.7 Weighted Portfolio of FX Strategies, 46316.3 Multiple Forms of FX Beta, 46516.4 Carry FX Indices from Banks, 46516.5 Trend-Following FX Indices from Banks, 46716.6 Conclusion, 468References, 46917 Active Currency Management Part II: Is There Skill or Alpha in Currency Investing? 47117.1 Introduction, 47117.2 Alternative Currency Management Mandates, 47317.2.1 Features of a Currency Mandate, 47317.2.2 Structural and Operational Choices, 47617.2.3 The Alpha Continuum and Implications of Active Currency Mandates, 47717.3 Benchmarks for Currency Fund Management, 47717.3.1 A Basic Factor Model for Currency Returns, 47917.4 Empirical Evidence with the Barclay Currency Traders Index and Individual Fund Managers, 48117.4.1 Empirical Evidence with the Barclay Currency Traders Index, 48117.4.2 Individual Currency Manager Returns, 48517.4.3 Alternative Information Ratio, 49317.5 Empirical Evidence: Fund Managers on the DB FX Select Platform, 49617.5.1 Grouping Managers into a Fund of Funds, 49617.6 Conclusions and Investment Implications, 498References, 49918 Currency Hedging for International Bond and Equity Investors 50318.1 Introduction, 50318.2 Overview of Empirical Hedging Studies, 50418.3 Return and Volatility Impact of Currency Hedging, 50618.3.1 Theoretical Background, 50618.3.2 Methodology, 50818.3.3 Summary of Findings on the Return and Volatility Impact of Currency Hedging, 52518.4 Hedge Instruments—Currency Forwards versus Options, 52618.4.1 Why Do Hedge Cash Flows Matter? 52618.4.2 Historical Performance of Hedging with Options, 52718.4.3 Summary of Findings on Hedging with Options Versus Forwards, 53218.5 Managing Tracking Error in Forward Hedges, 53318.5.1 How Often to Rebalance? 53318.5.2 Trigger-Based Versus Regular Rebalancing, 53918.5.3 Summary of Findings on Hedge Rebalancing, 53918.6 Conclusions, 541References, 54319 FX Reserve Management 54519.1 FX Reserve Management, 54519.2 FX Reserve Uses, 54519.3 FX Reserve Sources, 54619.4 Objectives of Reserves Management, 54719.5 Techniques of Reserve Management, 54719.6 Historical Perspective, 54819.7 What Assets Do Central Banks Hold? 54919.8 Constraints, 55019.9 External Managers, 55119.10 Costs of Accumulation and Holding of Reserves, 55119.11 Diversification, 55219.12 Challenges to Diversification and Size of Reserves, 55219.13 Changing Role of the Dollar as the International Reserve Currency, 55419.14 Reserve Management if the Dollar is Replaced as the Reserve Currency, 55719.15 Conclusion, 559Acknowledgments, 559References, 55920 High Frequency Finance: Using Scaling Laws to Build Trading Models 56320.1 Introduction, 56320.2 The Intrinsic Time Framework, 56520.3 Scaling Laws, 56720.3.1 The New Scaling Laws, 56820.3.2 The Coastline, 57320.4 The Scale of Market Quakes, 57420.5 Trading Models, 57720.5.1 Overview, 57720.5.2 Coastline Trader, 57820.5.3 Monthly Statistics, 58020.6 Conclusion, 582Acknowledgments, 582References, 58221 Algorithmic Execution in Foreign Exchange 58521.1 Introduction, 58521.1.1 Drawing from the Equity Market, 58621.1.2 What is Going to Work for Foreign Exchange? 58721.2 Key Components of an Algorithmic Execution Framework, 58921.2.1 Smart Order Routing (SOR), 58921.2.2 Intelligence, 59021.2.3 Speed, 59121.3 Types of Algorithms, 59221.3.1 Time Slicers, 59221.3.2 Sweeper, 59221.3.3 Iceberg, 59221.3.4 Opportunistic, 59221.3.5 Participators, 59421.3.6 Internalization Strategies, 59421.3.7 Dynamic Algorithms, 59521.4 What Execution Strategies are Most Effective? 59521.4.1 Measuring Performance, 59621.5 Looking Forward, 596Appendix A, 596References, 59722 Foreign Exchange Strategy Based Products 59922.1 Introduction, 59922.2 Evolution of the Foreign Exchange Market, 60022.2.1 Disappointing Early Years, 60022.2.2 Emergence of ‘‘Puzzles’’ in FX, 60122.2.3 Growth of FX Market Turnover and Currency Managers, 60222.3 Foreign Exchange Investable Indices and Strategy-Based Products, 60622.3.1 Why Profit Opportunities Exist? 60622.3.2 Beta and Alpha in Foreign Exchange, 60722.3.3 Why is FX Attractive? 61322.3.4 Why use Strategy-Based FX Products? 61922.4 Conclusion, 620References, 62023 Foreign Exchange Futures, Forwards, and Swaps 62323.1 Introduction, 62323.2 Market Basics and Size, 62523.2.1 FX Outright Forwards and Futures, 62523.2.2 FX Swaps and Cross-Currency Swaps, 62823.2.3 Market Size, 63523.3 Dislocations of the FX and Cross-Currency Swap Markets under Financial Crises, 63723.3.1 Japan Premium Case in the Late 1990s, 63723.3.2 The Global Financial Crisis from 2007, 63923.4 Conclusion, 643Acknowledgments, 643References, 64324 FX Options and Volatility Derivatives: An Overview from the Buy-SidePerspective 64724.1 Introduction, 64724.2 Why Would One Bother with an Option? 64824.2.1 History, 64824.2.2 FX Options, 64924.3 Market for FX Options, 65524.3.1 Overview, 65524.3.2 Players, 65624.3.3 Setting the Price, 65824.4 Volatility, 66024.4.1 Overview of Models, 66024.4.2 Some Stylized Facts and Implied Moments, 66424.4.3 Is Volatility an Asset Class? 66624.4.4 Anti-Black Swan Strategies, 67424.4.5 Black Swan Strategies, 67624.5 FX Options from the Buy-Side Perspective, 68324.5.1 Strike versus Leverage, 68324.5.2 Implied Distribution, 68524.5.3 Long-Dated Options versus Short-Dated Option, 68924.5.4 Black Swan Fund, 69224.5.5 Currency Hedging of Illiquid Assets, 693Acknowledgment, 695References, 695part four FX Markets and Policy25 A Common Framework for Thinking about Currency Crises 69925.1 Introduction, 69925.2 The KFG Model, 70125.3 Extensions, 70625.3.1 Attack-Conditional Monetary Policy, 70625.3.2 Devaluation, 70725.3.3 Sterilization and Interest Rate Defense, 70925.3.4 Lender of Last Resort and Currency Crises, 71125.4 Empirical Work, 71325.5 Conclusion, 714References, 71526 Official Intervention in the Foreign Exchange Market 71726.1 Introduction, 71726.2 Official FX Interventions and Reserve Accumulation: Stylized Facts, Motives, and Effects, 72126.3 Empirical Evidence on the Effectiveness of Official FX Interventions, 72526.3.1 A Simple Conceptual Framework, 72626.3.2 Time-Series Approach: Evidence on Effectiveness and Channels, 72826.3.3 Event-Study Approach: Evidence on Longer-Term Effectiveness, 73926.4 Conclusions, 74626.5 Acknowledgements, 746References, 74727 Exchange Rate Misalignment—The Case of the Chinese Renminbi 75127.1 Introduction, 75127.2 Background, 75227.3 Undervalued or Overvalued, 75427.3.1 The FEER Misalignment Estimate, 75427.3.2 The Penn Effect Regression, 75727.3.3 Data Revision, 75927.4 Concluding Remarks, 762Acknowledgments, 763References, 76328 Choosing an Exchange Rate Regime 76728.1 Five Advantages of Fixed Exchange Rates , 76828.2 Econometric Evidence on the Bilateral Trade Effects of Currency Regimes, 77028.2.1 Time-Series Dimension, 77128.2.2 Omitted Variables, 77228.2.3 Endogeneity of the Currency Decision, 77328.2.4 Implausible Magnitude of the Estimate, 77428.2.5 Country Size, 77528.3 Five Advantages of Floating Exchange Rates, 77528.4 How to Weigh Up the Advantages of Fixing Versus Floating, 77728.5 Country Characteristics That Should Help Determine the Choice of Regime, 77828.6 Alternative Nominal Anchors, 780References, 781Index 785