Using the Special Drawing Right in the Frankel-Wei regression framework

Abstract

The Frankel-Wei regression framework measures the comovements between currencies, and assumes that all foreign exchange rates share a common numéraire. The International Monetary Fund's (IMF) Special Drawing Right (SDR) is a regular choice for the common numéraire. However, the five-currency basket of the SDR lacks diversification, which results in significant positive comovements between the basket currencies and the SDR currency basket. Consequently, the estimator of the regression coefficient is biased away from its true value. We suggest that the common numéraire be a large well-diversified currency basket, rather than a small undiversified currency basket, such as the five-currency SDR.