Handbook of Exchange Rates
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Preface xxiii
Contributors xxvii
part one Overview
1 Foreign Exchange Market Structure, Players, and Evolution 3
1.1 Introduction, 3
1.2 Geography and Composition of Currency Trading, 4
1.2.1 Which Currencies are Traded? 6
1.2.2 What Instruments are Traded? 9
1.2.3 How is Trading Regulated? 9
1.3 Players and Information in FX Markets, 11
1.3.1 Who Needs Liquidity? 12
1.3.2 Who Provides Liquidity? 15
1.3.3 Asymmetric Information and Exchange Rate Determination, 19
1.4 Electronic Trading Revolution in FX Markets, 21
1.4.1 The Telephone Era, 22
1.4.2 The Rise of the Computer, 22
1.4.3 Recent Developments in Electronic Trading, 30
1.5 Survey of Multibank FX Platforms, 35
1.6 Summary, 38
Glossary, 39
Acknowledgments, 41
References, 42
2 Macro Approaches to Foreign Exchange Determination 45
2.1 Introduction, 45
2.2 Models of the Nominal Exchange Rate, 46
2.2.1 The Monetary Model, 46
2.2.2 Portfolio Balance Models, 49
2.2.3 Empirical Evidence, 51
2.3 Real Models of the Real Exchange Rate, 54
2.3.1 Purchasing Power Parity, 55
2.3.2 Balassa-Samuelson and Productivity-Based Models, 56
2.3.3 Two-Good Models, 59
2.4 New Directions in Exchange-Rate Modeling, 60
2.4.1 Taking Reaction Functions Seriously, 60
2.4.2 The Impact of Financial Globalization, 63
2.4.3 The Risk Premium and Order Flow, 64
2.5 Conclusions, 65
Acknowledgments, 65
References, 66
3 Micro Approaches to Foreign Exchange Determination 73
3.1 Introduction, 73
3.2 Perspectives on Spot-Rate Dynamics, 74
3.2.1 Decomposition of Depreciation Rates, 74
3.2.2 Macro- and Microperspectives, 77
3.3 Currency Trading Models and their Implications, 80
3.3.1 The Portfolio Shifts Model, 81
3.3.2 Empirical Implications, 88
3.4 Exchange Rates, Order Flows, and the Macro Economy, 95
3.4.1 A Micro-Based Macro model, 96
3.4.2 Empirical Implications, 100
3.5 Conclusion, 105
Appendix, 105
3.6 Acknowledgment, 108
References, 108
4 The Exchange Rate in a Behavioral Finance Framework 111
4.1 Introduction, 111
4.1.1 Mainstream Exchange Rate Models, 111
4.1.2 Away from the Mainstream, 113
4.2 Exchange Rate Puzzles, 114
4.2.1 Disconnect Puzzle and Excess Volatility Puzzle, 114
4.2.2 Unit Root Property, 115
4.2.3 Volatility Clustering, 118
4.2.4 Fat-Tailed Distributed Exchange Rate Returns, 119
4.3 A Prototype Behavioral Model of the Foreign Exchange Market, 122
4.4 Conclusion, 127
References, 129
5 The Evolution of Exchange Rate Regimes and Some Future Perspectives 133
5.1 Introduction, 133
5.2 A Brief History of Currency Regimes, 135
5.3 Performance of the Laisser-Faire Exchange Rate System, 1973-2010, 138
5.3.1 Market Discipline, 139
5.3.2 Economic Policy Coordination, 140
5.3.3 Integration of Emerging Market Countries into the Global Economy, 140
5.4 Trends in Currency Use, 141
5.4.1 Global Imbalances and the Financial Crisis of 2007-2009, 143
5.5 Prospects for the Future, 144
5.5.1 The Current System, 144
5.5.2 Toward a more Managed International Monetary System? 146
5.5.3 How and When Will Reform Occur? 150
5.5.4 A Global Nominal Anchor? 151
5.6 Concluding Comments, 153
Appendix A: A Formal Test of Hollowing Out, 154
References, 156
part two Exchange Rate Models and Methods
6 Purchasing Power Parity in Economic History 161
6.1 Introduction, 161
6.2 Categorization of Purchasing-Power-Parity Theories, 162
6.3 Historical Application of PPP: Premodern Periods, 163
6.3.1 Ancient Period, 163
6.3.2 Medieval Period, 164
6.3.3 Sixteenth-Century Spain, 165
6.4 Techniques of Testing PPP Theory in Economic-History Literature, 165
6.4.1 Comparative-Static Computation, 165
6.4.2 Regression Analysis, 165
6.4.3 Testing for Causality, 165
6.4.4 Nonstationarity and Spurious Regression, 166
6.4.5 Testing for Stationarity, 167
6.4.6 Cointegration Analysis, 167
6.5 Price Variable in PPP Computations, 168
6.6 Modern Period: Testing of PPP, 169
6.6.1 Early North America, 169
6.6.2 Bullionist Periods, 170
6.6.3 Floating Rates-Second-Half of Nineteenth Century, 171
6.6.4 Classic Metallic Standards, 172
6.6.5 World War I, 172
6.6.6 Floating Rates-1920s, 173
6.6.7 1930s, 175
6.6.8 Interwar Period, 175
6.6.9 Spain-Long Term, 176
6.6.10 Guatemala-Long Term, 176
6.7 Analysis of U.S. Return to Gold Standard in 1879, 177
6.8 Establishment and Assessment of a Fixed Exchange Rate in Interwar Period, 177
6.8.1 United Kingdom, 177
6.8.2 France, 179
6.9 Conclusions, 180
References, 181
7 Purchasing Power Parity in Tradable Goods 189
7.1 Introduction, 189
7.2 The LOP and Price Indices, 190
7.3 Empirical Evidence on the LOP, 194
7.3.1 Early Tests of the LOP, 194
7.3.2 The Border Effect, 194
7.3.3 Barriers to Arbitrage and Nonlinearities, 195
7.3.4 The Tradable Versus Nontradable Goods Dichotomy, 198
7.3.5 The Aggregation Bias and Micro Price Studies, 199
7.4 Purchasing Power Parity, 200
7.4.1 Transitory and Structural Disparities from Parity, 203
7.5 Aggregating from the LOP to PPP: What Can We Infer? 205
7.5.1 An Eyeball Analysis of PPP, 207
7.6 Conclusion and Implications, 213
Appendix: TAR Modeling, 214
Acknowledgments, 215
References, 215
8 Statistical and Economic Methods for Evaluating Exchange Rate Predictability 221
8.1 Introduction, 221
8.2 Models for Exchange Rate Predictability, 224
8.2.1 A Present Value Model for Exchange Rates, 224
8.2.2 Predictive Regressions, 226
8.3 Statistical Evaluation of Exchange Rate Predictability, 228
8.4 Economic Evaluation of Exchange Rate Predictability, 231
8.4.1 The Dynamic FX Strategy, 231
8.4.2 Mean-Variance Dynamic Asset Allocation, 231
8.4.3 Performance Measures, 232
8.4.4 Transaction Costs, 234
8.5 Combined Forecasts, 235
8.6 Empirical Results, 237
8.6.1 Data on Exchange Rates and Economic Fundamentals, 237
8.6.2 Predictive Regressions, 242
8.6.3 Statistical Evaluation, 244
8.6.4 Economic Evaluation, 249
8.7 Conclusion, 256
Appendix A: The Bootstrap Algorithm, 259
Acknowledgments, 260
References, 260
9 When Are Pooled Panel-Data Regression Forecasts of Exchange Rates More Accurate than the Time-Series Regression Forecasts? 265
9.1 Introduction, 265
9.2 Panel Data Exchange Rate Determination Studies, 267
9.3 Asymptotic Consequences of Pooling, 268
9.3.1 Predictive Regression Estimated on Full Sample, 268
9.3.2 Out-of-Sample Prediction, 271
9.4 Monte Carlo Study, 272
9.5 An Illustration with Data, 275
9.6 Conclusions, 278
References, 279
10 Carry Trades and Risk 283
10.1 Introduction, 283
10.2 The Carry Trade: Basic Facts, 285
10.2.1 What is a Carry Trade? 285
10.2.2 Measuring the Returns to the Carry Trade, 286
10.3 Pricing the Returns to the Carry Trade, 290
10.4 Empirical Findings, 293
10.4.1 Traditional Risk Factors, 293
10.4.2 Factors Derived from Currency Returns, 299
10.5 Time-Varying Risk and Rare Events, 308
10.6 Conclusion, 311
Acknowledgments, 311
References, 311
11 Currency Fair Value Models 313
11.1 Introduction, 313
11.2 Models/Taxonomy, 315
11.2.1 ''Adjusted PPP'': Harrod-Balassa-Samuelson and Penn Effects, 315
11.2.2 The Behavioral Equilibrium Exchange Rate Family of Models, 316
11.2.3 The Underlying Balance (UB) Approach, 320
11.2.4 External Sustainability (ES) Approach, 324
11.2.5 The Natural Real Exchange Rate (NATREX), 325
11.2.6 The Indirect Fair Value (IFV), 325
11.3 Implementation Choices and Model Characteristics, 328
11.3.1 Horizon/Frequency, 329
11.3.2 Direct Econometric Estimation Versus ''Methods of Calculation'', 331
11.3.3 Treatment of External Imbalances , 332
11.3.4 Real Versus Nominal Exchange Rates, 333
11.3.5 Bilateral Versus Effective Exchange Rate, 333
11.3.6 Time Series Versus Cross Section or Panel, 336
11.3.7 Model Maintenance, 336
11.4 Conclusion, 337
Acknowledgments, 338
References, 339
12 Technical Analysis in the Foreign Exchange Market 343
12.1 Introduction, 343
12.2 The Practice of Technical Analysis, 345
12.2.1 The Philosophy of Technical Analysis, 345
12.2.2 Types of Technical Analysis, 346
12.3 Studies of Technical Analysis in the Foreign Exchange Market, 350
12.3.1 Why Study Technical Analysis? 350
12.3.2 Survey Evidence on the Practice of Technical Analysis, 350
12.3.3 Computing Signals and Returns, 351
12.3.4 Early Studies: Skepticism before the Tide Turns, 353
12.3.5 Pattern Recognition, Intraday Data, and Other Exchange Rates, 353
12.4 Explaining The Success of Technical Analysis, 355
12.4.1 Data Snooping, Publication Bias, and Data Mining, 355
12.4.2 Temporal Variation in Trading Rule Returns, 357
12.4.3 Do Technical Trading Returns Compensate Investors for Bearing Risk? 359
12.4.4 Does Foreign Exchange Intervention Create Trading Rule Profits? 361
12.4.5 Do Cognitive Biases Create Trading Rule Profits? 363
12.4.6 Do Markets Adapt to Arbitrage Away Trading Rule Profits? 365
12.5 The Future of Research on Technical Analysis, 366
12.6 Conclusion, 367
Acknowledgments, 368
References, 368
13 Modeling Exchange Rates with Incomplete Information 375
13.1 Introduction, 375
13.2 Basic Monetary Model, 376
13.3 Information Heterogeneity, 379
13.4 Model Uncertainty, 381
13.5 Infrequent Decision Making, 385
13.6 Conclusion, 388
Acknowledgments, 388
References, 389
14 Exchange Rates in a Stochastic Discount Factor Framework 391
14.1 Introduction, 391
14.2 Exchange Rates and Stochastic Discount Factors, 392
14.2.1 Stochastic Discount Factors, 392
14.2.2 Real Exchange Rates and Currency Risk Premia, 395
14.3 Empirical Evidence, 398
14.3.1 From UIP Regressions to Currency Portfolios, 398
14.3.2 Annual Currency Excess Returns and Aggregate Risk, 399
14.3.3 Monthly Currency Excess Returns, 403
14.3.4 Implications for Stochastic Discount Factors, 403
14.3.5 Predictability of Currency Excess Returns, 405
14.4 Models, 407
14.4.1 Habits, 407
14.4.2 Long-Run Risk, 411
14.4.3 Disaster Risk, 414
14.5 Conclusion, 417
References, 417
15 Volatility and Correlation Timing in Active Currency Management 421
15.1 Introduction, 421
15.2 Dynamic Models for Volatility and Correlation, 424
15.2.1 The Set of Multivariate Models, 425
15.2.2 The Set of Univariate Models for Volatility Timing, 427
15.2.3 Pairwise Model Comparisons, 427
15.2.4 Estimation and Forecasting, 427
15.3 The Economic Value of Volatility and Correlation Timing, 428
15.3.1 The Dynamic Strategy, 428
15.3.2 Dynamic Asset Allocation with CRRA Utility, 428
15.3.3 Performance Measures, 429
15.3.4 Transaction Costs, 430
15.4 Parameter Uncertainty in Bayesian Asset Allocation, 430
15.5 Model Uncertainty, 431
15.5.1 The BMA Strategy, 432
15.5.2 The BMW Strategy, 432
15.6 Empirical Results, 432
15.6.1 Data and Descriptive Statistics, 432
15.6.2 Bayesian Estimation, 433
15.6.3 Evaluating Volatility and Correlation Timing, 434
15.7 Conclusion, 440
Appendix A: Univariate Models for Volatility Timing, 442
Appendix B: Parameter Uncertainty and the Predictive Density, 443
Acknowledgments, 444
References, 444
part three FX Markets and Products
16 Active Currency Management Part I: Is There a Premium for Currency Investing (Beta) 453
16.1 Introduction, 453
16.2 Beta in the Foreign Exchange Markets, 455
16.2.1 Understanding the FX Carry Trade, 455
16.2.2 FX Carry as a Broader Strategy, 456
16.2.3 FX Trend-Based Strategies, 458
16.2.4 Value-Based Strategies Within FX, 460
16.2.5 USD Directional Trade, 461
16.2.6 Correlation between these FX Strategies and Other Forms of Beta, 462
16.2.7 Weighted Portfolio of FX Strategies, 463
16.3 Multiple Forms of FX Beta, 465
16.4 Carry FX Indices from Banks, 465
16.5 Trend-Following FX Indices from Banks, 467
16.6 Conclusion, 468
References, 469
17 Active Currency Management Part II: Is There Skill or Alpha in Currency Investing? 471
17.1 Introduction, 471
17.2 Alternative Currency Management Mandates, 473
17.2.1 Features of a Currency Mandate, 473
17.2.2 Structural and Operational Choices, 476
17.2.3 The Alpha Continuum and Implications of Active Currency Mandates, 477
17.3 Benchmarks for Currency Fund Management, 477
17.3.1 A Basic Factor Model for Currency Returns, 479
17.4 Empirical Evidence with the Barclay Currency Traders Index and Individual Fund Managers, 481
17.4.1 Empirical Evidence with the Barclay Currency Traders Index, 481
17.4.2 Individual Currency Manager Returns, 485
17.4.3 Alternative Information Ratio, 493
17.5 Empirical Evidence: Fund Managers on the DB FX Select Platform, 496
17.5.1 Grouping Managers into a Fund of Funds, 496
17.6 Conclusions and Investment Implications, 498
References, 499
18 Currency Hedging for International Bond and Equity Investors 503
18.1 Introduction, 503
18.2 Overview of Empirical Hedging Studies, 504
18.3 Return and Volatility Impact of Currency Hedging, 506
18.3.1 Theoretical Background, 506
18.3.2 Methodology, 508
18.3.3 Summary of Findings on the Return and Volatility Impact of Currency Hedging, 525
18.4 Hedge Instruments-Currency Forwards versus Options, 526
18.4.1 Why Do Hedge Cash Flows Matter? 526
18.4.2 Historical Performance of Hedging with Options, 527
18.4.3 Summary of Findings on Hedging with Options Versus Forwards, 532
18.5 Managing Tracking Error in Forward Hedges, 533
18.5.1 How Often to Rebalance? 533
18.5.2 Trigger-Based Versus Regular Rebalancing, 539
18.5.3 Summary of Findings on Hedge Rebalancing, 539
18.6 Conclusions, 541
References, 543
19 FX Reserve Management 545
19.1 FX Reserve Management, 545
19.2 FX Reserve Uses, 545
19.3 FX Reserve Sources, 546
19.4 Objectives of Reserves Management, 547
19.5 Techniques of Reserve Management, 547
19.6 Historical Perspective, 548
19.7 What Assets Do Central Banks Hold? 549
19.8 Constraints, 550
19.9 External Managers, 551
19.10 Costs of Accumulation and Holding of Reserves, 551
19.11 Diversification, 552
19.12 Challenges to Diversification and Size of Reserves, 552
19.13 Changing Role of the Dollar as the International Reserve Currency, 554
19.14 Reserve Management if the Dollar is Replaced as the Reserve Currency, 557
19.15 Conclusion, 559
Acknowledgments, 559
References, 559
20 High Frequency Finance: Using Scaling Laws to Build Trading Models 563
20.1 Introduction, 563
20.2 The Intrinsic Time Framework, 565
20.3 Scaling Laws, 567
20.3.1 The New Scaling Laws, 568
20.3.2 The Coastline, 573
20.4 The Scale of Market Quakes, 574
20.5 Trading Models, 577
20.5.1 Overview, 577
20.5.2 Coastline Trader, 578
20.5.3 Monthly Statistics, 580
20.6 Conclusion, 582
Acknowledgments, 582
References, 582
21 Algorithmic Execution in Foreign Exchange 585
21.1 Introduction, 585
21.1.1 Drawing from the Equity Market, 586
21.1.2 What is Going to Work for Foreign Exchange? 587
21.2 Key Components of an Algorithmic Execution Framework, 589
21.2.1 Smart Order Routing (SOR), 589
21.2.2 Intelligence, 590
21.2.3 Speed, 591
21.3 Types of Algorithms, 592
21.3.1 Time Slicers, 592
21.3.2 Sweeper, 592
21.3.3 Iceberg, 592
21.3.4 Opportunistic, 592
21.3.5 Participators, 594
21.3.6 Internalization Strategies, 594
21.3.7 Dynamic Algorithms, 595
21.4 What Execution Strategies are Most Effective? 595
21.4.1 Measuring Performance, 596
21.5 Looking Forward, 596
Appendix A, 596
References, 597
22 Foreign Exchange Strategy Based Products 599
22.1 Introduction, 599
22.2 Evolution of the Foreign Exchange Market, 600
22.2.1 Disappointing Early Years, 600
22.2.2 Emergence of ''Puzzles'' in FX, 601
22.2.3 Growth of FX Market Turnover and Currency Managers, 602
22.3 Foreign Exchange Investable Indices and Strategy-Based Products, 606
22.3.1 Why Profit Opportunities Exist? 606
22.3.2 Beta and Alpha in Foreign Exchange, 607
22.3.3 Why is FX Attractive? 613
22.3.4 Why use Strategy-Based FX Products? 619
22.4 Conclusion, 620
References, 620
23 Foreign Exchange Futures, Forwards, and Swaps 623
23.1 Introduction, 623
23.2 Market Basics and Size, 625
23.2.1 FX Outright Forwards and Futures, 625
23.2.2 FX Swaps and Cross-Currency Swaps, 628
23.2.3 Market Size, 635
23.3 Dislocations of the FX and Cross-Currency Swap Markets under Financial Crises, 637
23.3.1 Japan Premium Case in the Late 1990s, 637
23.3.2 The Global Financial Crisis from 2007, 639
23.4 Conclusion, 643
Acknowledgments, 643
References, 643
24 FX Options and Volatility Derivatives: An Overview from the Buy-Side
Perspective 647
24.1 Introduction, 647
24.2 Why Would One Bother with an Option? 648
24.2.1 History, 648
24.2.2 FX Options, 649
24.3 Market for FX Options, 655
24.3.1 Overview, 655
24.3.2 Players, 656
24.3.3 Setting the Price, 658
24.4 Volatility, 660
24.4.1 Overview of Models, 660
24.4.2 Some Stylized Facts and Implied Moments, 664
24.4.3 Is Volatility an Asset Class? 666
24.4.4 Anti-Black Swan Strategies, 674
24.4.5 Black Swan Strategies, 676
24.5 FX Options from the Buy-Side Perspective, 683
24.5.1 Strike versus Leverage, 683
24.5.2 Implied Distribution, 685
24.5.3 Long-Dated Options versus Short-Dated Option, 689
24.5.4 Black Swan Fund, 692
24.5.5 Currency Hedging of Illiquid Assets, 693
Acknowledgment, 695
References, 695
part four FX Markets and Policy
25 A Common Framework for Thinking about Currency Crises 699
25.1 Introduction, 699
25.2 The KFG Model, 701
25.3 Extensions, 706
25.3.1 Attack-Conditional Monetary Policy, 706
25.3.2 Devaluation, 707
25.3.3 Sterilization and Interest Rate Defense, 709
25.3.4 Lender of Last Resort and Currency Crises, 711
25.4 Empirical Work, 713
25.5 Conclusion, 714
References, 715
26 Official Intervention in the Foreign Exchange Market 717
26.1 Introduction, 717
26.2 Official FX Interventions and Reserve Accumulation: Stylized Facts, Motives, and Effects, 721
26.3 Empirical Evidence on the Effectiveness of Official FX Interventions, 725
26.3.1 A Simple Conceptual Framework, 726
26.3.2 Time-Series Approach: Evidence on Effectiveness and Channels, 728
26.3.3 Event-Study Approach: Evidence on Longer-Term Effectiveness, 739
26.4 Conclusions, 746
26.5 Acknowledgements, 746
References, 747
27 Exchange Rate Misalignment-The Case of the Chinese Renminbi 751
27.1 Introduction, 751
27.2 Background, 752
27.3 Undervalued or Overvalued, 754
27.3.1 The FEER Misalignment Estimate, 754
27.3.2 The Penn Effect Regression, 757
27.3.3 Data Revision, 759
27.4 Concluding Remarks, 762
Acknowledgments, 763
References, 763
28 Choosing an Exchange Rate Regime 767
28.1 Five Advantages of Fixed Exchange Rates , 768
28.2 Econometric Evidence on the Bilateral Trade Effects of Currency Regimes, 770
28.2.1 Time-Series Dimension, 771
28.2.2 Omitted Variables, 772
28.2.3 Endogeneity of the Currency Decision, 773
28.2.4 Implausible Magnitude of the Estimate, 774
28.2.5 Country Size, 775
28.3 Five Advantages of Floating Exchange Rates, 775
28.4 How to Weigh Up the Advantages of Fixing Versus Floating, 777
28.5 Country Characteristics That Should Help Determine the Choice of Regime, 778
28.6 Alternative Nominal Anchors, 780
References, 781
Index 785
