LECTURE 3: Section 1. Forecasting Currency Returns: Exchange Rate Puzzles. Puzzle 1: Why don’t the “fundamentals” explain exchange rates?. If not fundamentals, then ??? Speculative bubble? Nonrational behavior (systematic forecasting errors)? Omitted variables? Recall the hybrid model:
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Forecasting Currency Returns:
Exchange Rate Puzzles
If not fundamentals, then ???
Recall the hybrid model:
Daily model of foreign exchange market: round 1
i) Observe daily returns as realized increments of macro info:
ii) Dealers quote to customers,
iii) Receive customer order
Round 2: Interdealer trades
Round 3: Dealers share risk with public
Evans & Lyons estimated model of:
Managed exchange rates less volatile than floating exchange rates, but macro determinants shouldn’t vary with regime so can macro factors really be important?
KLM estimate model of flexible rates prior to euro fixings of May 4, 1998
Forward rate typically predicts change in exchange rate with wrong sign
Practitioner’s perspective: is bias large enough to generate a Sharpe ratio comparable to buy & hold equity strategy
Why is b estimate closer to -1 lower bound?
Galati & Heath
Why are nonfinancial customers the fastest growing segment of the FX market?
Leveraged investors have earned attractive SR from currency strategies
AUM grew with currencies’ development as an asset class
Growth of PB services
Algorithmic trading (don’t know how much)
Growth of emerging markets
Cheung & Chinn
Survey of US FX Dealers
65% of trades interbank, 35% customer
Large player advantage from large customer base
Exchange rates unpredictable intraday but more predictable over period of months
Trading methods evenly distributed over
News effects reflected in exchange rates largely within 1 minute
Exchange rates only reflect fundamental value in long-run
Brunnermeir et al.
Carry Trade & Crash Risk
Reflected in skewness of currency returns
Price of crash risk
8 currencies versus USD
Abnormal return measured as:
Estimate models with excess returns, positioning, & skewness on LHS of regression
Also estimate density of FX returns conditional on interest differential
Regress skewness at t+1 & risk reversals at t on
Would expect redemptions, margin calls, lower risk tolerance to motivate unwinds
Estimate model of change in carry positioning as f(VIX, lagged positioning)
Estimate model of change in RR as f(VIX, lagged RR)
Estimate model of z on same
Replace VIX with TED spread & find useful for predicting future change in RR & z
If carry trades affected by shifts in risk tolerance should expect funding currencies to all move together and same should be true for investment currencies
Estimate model of pairwise correlation of exchange rate changes (13 week non-overlapping) as f(abs value of interest differential, correlation of interest rate levels (monetary policy control), and average correlation across all pairs of exchange rates (common factor in all correlations)