Base Currency Research Articles

Investor sentiments and exchange rate volatility

In this paper, we have investigated the role of investor sentiments on the exchange rate volatility in our emerging market. In the past there were many studies that tried to capture the impact of investor sentiments on the stock market returns but the exchange rates are also one of the important economic indicators and is frequently used as the stock market returns and interest rates etc, so we have tried to see the impact of investor sentiments on the exchange rate volatility. The data has been collected from International Monetary Fund website, Karachi Stock Exchange for stock returns and for the purpose to collect various sentimental proxies to measure sentimental index. Also we have not collected exchange rate data in relation to a single base currency rather we have selected a basket of currency i.e., SDR composing mainly of currencies like US dollar, Japanese Yen, Swiss Franc, Pound and Mexican Lira. For empirical testing we have used the sentiment equation mainly composing of six sentimental proxies that are dividend premium, number of initial public issues in a single year, closed end mutual fund discount, first day return on initial public offering, share turnover in Karachi Stock Exchange and equity share in total equity and long term debt issuance. We have run regression on the exchange rate volatility and independent variable was investor sentiment that we have used described above. Before that we also had applied Augmented Dickey Fuller test to check the stationarity and we have applied first differencing to make the time series stationary as in the first level place the series was unit root. Final results confirmed that the investor sentiments did explain the volatility in the exchange rates although the impact is low suggesting that there may be many other factors that explains the variation in the exchange rates

A Refined Basket of Goods Approach for Comparing Construction Costs between Countries

Most comparisons of construction industry performance requirethat construction costs be converted to a common base. Existingmechanisms for such conversions produce unreliable results.A proposed method for producing industry-specifi c conversionfactors was tested using a single building type. A basket ofmaterials and labour was identifi ed and weighted to refl ect the costshare of each item in a completed project. Prices for the basketwere gathered in three cities and simple construction specifi cconversion indices were calculated based on the constructionpurchasing power of each currency. The construction purchasingpower parities (CPPPs) showed marked differences from otheravailable conversion mechanisms such as exchange rates andgeneral purchasing power parities (PPPs) that have been used inprevious international comparison studies. While the study waslimited in scope, and is only the fi rst stage of a longer process, thesubstantial differences in comparative costs based on purchasingpower illustrate the problems inherent in international costcomparisons. For example, comparing Singapore and Sydney,Singapore costs appear to be only 40% of those in Sydney (basedon exchange rates) about two-thirds the cost of Sydney (usinggeneral PPPs) or almost the same (using the preliminary CPPPs).These results illustrate the problems of converting costs fromlocal currencies to a single base currency and suggest that furtherdevelopment is needed to improve the reliability of outcomes.

Choice of RMB appreciation speed and amplitude

Purpose – The purpose of this paper is to analyse the implications of exchange rate fluctuations on China's national macro‐financial stability and evaluate current renminbi (RMB) appreciation speed and magnitude.Design/methodology/approach – The contingent claims analysis method is used to construct the financial risk indicator and evaluate the macro‐financial risk. The paper also implemented computer simulations to generate different scenarios in the macro‐scenario analysis.Findings – The main conclusion is that there is claims‐based currency mismatch in China's four major economic sectors. The simulation results show that faster appreciation leads to wide fluctuations on asset prices, the size of the base currency and foreign debt in China. In the current risk level, steady speed appreciation style is better than the accelerated appreciation style.Social implications – The results of this paper imply that current appreciation speed and magnitude are favorable to control macro‐financial risks within safe...

The Safe-Haven Effect in Forward Premia: What Makes a Currency Trustworthy?

Recently, the role of safe-haven currency has become increasingly remarkable: in the time of stress, uncertainty aversion drives investors to shun the risky currencies and fly for quality. The currency that serves as a safe haven also acts as the benchmark for performance measurement. In this paper we explore what contributes to a safe-haven or benchmark image of currency in turbulence. By comparing floating rates to band-regime ones, strong base currencies to weak ones, and the base currencies with different market shares, we find that the benchmarking role primarily comes from currency' strength measured by interest rate differential. However a low interest rate is not sufficient. A trustworthy currency also has large share in FX markets as well, and in this sense our safe-haven effect is not a pure carry-trade-cycle effect. The exchange-rate regime seems to matter the least. Besides, we find that consistent with the idea that reputation comes from a slow-moving effect, the safe-haven evidence is especially present in the long-run-trend component of the forwardpremium.

Comparison of risks based on the expected proportional shortfall

In this paper, we consider a new criterion to compare risks based on the notion of expected proportional shortfall. This criterion is useful for comparing risks of different nature and does not depend on the base currency. We study its relationships with other criteria and provide some characterizations that highlight the role of this new criterion in the context of comparisons of risks.

Dynamic linkages among equity markets: local versus basket currencies

This article compares the stability of interrelationships among nine national equity markets by employing basket currencies versus individual base currencies to measure rates of return. We show that the average correlations of equity indexes based on basket currencies are much lower than the average correlations of equity indexes based on individual home base currencies. Additionally, empirical directed graph results from using basket currencies are more consistent with each other than the results from using different individual currencies. We conclude that basket currencies provide more robust results for studying equity market comovements than individual currencies. By implication, studies on equity market interrelationships, including studies on potential financial contagion between equity markets, should use basket currencies to avoid currency dependent results.

Risk Transfer Arrangements as a Hedging Device with Evidence from the Kuwaiti Dinar-British Pound Market

An operational hedging technique is proposed to shift some of the foreign exchange risk from the importer to the exporter when the currency of invoicing is the base currency of the exporter. This technique, which may be resorted to when financial hedging is not feasible or expensive, requires an arrangement for the conversion of cash flows at a range of exchange rates calculated as some weighted average of the rates used under a risk sharing arrangement and a currency collar. The problem of negotiating the dimensions of the arrangement when the exporter and importer have different degrees of risk tolerance can be resolved by fine tuning the weights in such a way as to eliminate the sensitivity of the base currency value of the cash flow to the value of the risk sharing threshold parameter. The theory is subsequently illustrated by using monthly observations on the exchange rate between the Kuwaiti dinar and the British pound.

Mutual Fund Performance and Embedded Currency Risk

We study the determinants of currency management in international equity-only funds and their implications for fund performance. We argue that base currency and style affiliation determine the exposure of funds to currency risk – both currency volatility risk and crisis risk. The manager can indirectly hedge currency risk by adjusting the currency weights of its equity portfolio. However, the need to hedge currency risk introduces constraints on the equity selection that reduces performance. We test this using a complete worldwide sample of international mutual funds. We focus on three key currency policies: investment weight in the base currency, currency concentration and currency herding with other fund managers. We illustrate their link to currency risk and their impact on performance. Funds with more concentrated currency portfolios deliver an annualized performance 100–200 basis points lower than those with a less concentrated portfolio, while funds with a higher percentage invested in the local currency have a performance 100–200 basis points lower than those with lower percentage invested in the local currency.

Global Currency Hedging: What Role Should Foreign Currency Play in a Diversified Investment Portfolio?

Currency hedging is an important tool in reducing portfolio volatility for globally diversified equity and bond investors. Equity investors whose base currency is a reserve currency should fully hedge or even overhedge. Bond investors, regardless of their base currency, should also fully hedge.

The profitability of interest arbitrage when the base currency is pegged to a basket

When the interest rate on a currency that is pegged to a basket differs from the interest rate on the basket (as a weighted average), it is possible to make profit from interest arbitrage by going short on the basket and long on the pegged currency, or vice versa. This proposition is illustrated by using data on the Kuwaiti dinar and its basket currencies over the period 1998–2002 when the currency was pegged to a basket. Monte Carlo simulations show that the probability of making arbitrage profit from any single operation is about 95%.

Sign and Amplitude Representation of the Forex Networks

We decompose the exchange rates returns of 38 currencies (including gold) into their sign and amplitude components. Then we group together all exchange rates with a common base currency, construct Minimal Spanning Trees for each group independently, and analyze properties of these trees. We show that both the sign and the amplitude time series have similar correlation properties as far as the core network structure is concerned. There exist however interesting peripheral differences that may open a new perspective to view the Forex dynamics.

Real exchange rate behavior and optimum currency area in East Asia: Evidence from Generalized Purchasing Power Parity

In the aftermath of the Asian financial crisis, the need for monetary and exchange rate cooperation among the Asian countries has increased considerably. In this context, we attempt to evaluate the potential of an optimum currency area (OCA) for a group of eight East Asian countries. For this purpose, this study tests Purchasing Power Parity (PPP) and Generalized PPP (GPPP) hypothesis, which provides stylized facts of real exchange rate. Specifically, we attempt to investigate the symmetry in macroeconomic disturbances and the co-movements of bilateral real exchange rates of the East Asian countries as one of the standard minimum precondition for forming an OCA. Contrary to many previous studies, we find some supportive evidence for GPPP which, in turn, provides support for the feasibility of an optimum currency area in East Asia. However, the presence of asymmetries in the process, through which countries adjust to shocks in the system, indicates that still higher level of economic integration is required to strengthen the case of a currency union. More importantly, our overall results appear to be invariant to the choice of a base currency and therefore it provides support to the argument that both US dollar and Japanese Yen are important for East Asia while considering the case of a currency union.

The Forward Puzzle: The Roles of Exchange Rate Regime and Base Currency Strength

ABSTRACTThe forward puzzle is traditionally explained as the presence of a covariance‐risk premium, market friction or limits to arbitrage. Recently, Liu and Sercu, working on intra‐ERM rates for the DEM, presented evidence consistent with career risk considerations: portfolio managers shun assets with danger signals. In this paper, we test the external validity of this finding: we compare floating rates to band regimes, and strong base currencies to weak ones. We find that both the exchange rate regime and base currency strength influence the evidence on various theories: floating and strong intra‐ERM rates weakly support market friction or limit‐to‐arbitrage theories, while the HKD and weak intra‐ERM strongly support the career risk effect. We also decompose forward premium into a short‐term filtered component and a long memory trend. The filtered component is good at recognising danger signals or ‘extreme’ observation effects for band regime rates and weak floaters, while the trend works best for strong floaters. Lastly, the filtered premium provides the best fit, consistent with the idea that it has a closer link to expectations than the trend component.

Currency Hedging: A Free Lunch?

We address the question of whether currency hedging is a 'free lunch' of risk reduction and zero expected returns. Using a long history of hedged and unhedged MSCI indices, we find that hedging does not always reduce risk and mean returns are not zero. Contrary to prior studies, we find there is no free lunch for the equity investor. Instead, we conclude that the usual, intuitive relationships hold: less risk means lower returns, and more risk, higher returns. Our research indicates that the decision whether to hedge depends not only on the base currency, market, and hedging horizon, but also on the investor's goals.

Analysis of a network structure of the foreign currency exchange market

We analyse structure of the world foreign currency exchange (FX) market viewed as a network of interacting currencies. We analyse daily time series of FX data for a set of 63 currencies, including gold, silver and platinum. We group together all the exchange rates with a common base currency and study each group separately. By applying the methods of filtered correlation matrix we identify clusters of closely related currencies. The clusters are formed typically according to the economical and geographical factors. We also study topology of weighted minimal spanning trees for different network representations (i.e., for different base currencies) and find that in a majority of representations the network has a hierarchical scale-free structure. In addition, we analyse the temporal evolution of the network and detect that its structure is not stable over time. A medium-term trend can be identified which affects the USD node by decreasing its centrality. Our analysis shows also an increasing role of euro in the world’s currency market.

Why are Some Currencies Viewed as Benchmarks? The Roles of Interest Rates, Economic Size, and Exchange-Rate Regime

The forward puzzle is traditionally explained as the reflection of a covariance-risk premium, market friction or limits to arbitrage. Recently, Liu and Sercu (2009; henceforth LS), working on intra-ERM rates for the DEM, presented evidence consistent with career-risk considerations (portfolio managers shun assets with danger signals), or with investors otherwise assign fallen-angel status to such assets. In this paper, we test the external validity of this finding: we compare floating rates to band-regime ones, strong base currencies to weak ones, and large economies to small ones. We find that the exchange-rate regime seems to matter the least; but the bench-marking role can come from either a huge economy (the U.S.), a strong currency (Swiss Franc, Dutch Guilder), or good ratings on both counts (Japan and Germany). Consistent with the idea that these are slow-moving reputational effects, the evidence is especially present in the long-run-trend component of the forward premium. In the short-run, filtered part, other factors seem to be at work.

A century of PPP: supportive results from nonlinear unit root tests

In this paper, we test Purchasing Power Parity (PPP) by applying a new unit root test that allows for nonlinearity in the data to the real exchange rates, constructed with a century of data of 20 countries from Taylor (2002). The problem of lag selection has been taken into account in testing as recommended by Lopez et al. (2005), who challenged Taylor's conclusion that PPP holds well over the 20th century. The results support PPP in 16 out of 19 cases when the US dollar is used as base currency, a result much closer to Taylor (2002) than Lopez et al. (2005) and in line with Wallace and Shelley (2006).

The Forward Puzzle: the Roles of Exchange-Rate Regime and Base-Currency Strength

The forward puzzle is traditionally explained as the presence of a covariance-risk premium (Bansal, 1997), market friction (Huisman et al, 1998) or limits to arbitrage (Sarno et al, 2006). More recently, Liu and Sercu (2007) present evidence consistent with career-risk or fallen-angel hypothesis, which states that portfolio managers shun assets with danger signals, like a strong forward discount, unlike most other, their test work is with intra-ERM rates for the DEM. So, the question arises whether this pattern is also existing in floating rates against the USD; and if not, what makes the diference: is it the exchange rate regime or the strength of the base currency? Thus, in this paper we apply the Liu-Sercu tests to (i) mainstream floating rates against the USD; (ii) the HKD pegged to the USD; (iii) intra-ERM rates for the DEM, a strong base currency; and (iv) intra-ERM rates for the ITL, a weak base currency. We find that the floaters support market friction or limit-to-arbitrage theories but the nonlinearity of the model is insignificant. Under the band regimes, the nonlinearity is more significant, the strong currencies favorite market friction and limit-to-arbitrage theories but the weak currencies support the career-risk effect. We also find that the forward premium is less stationary under the floating regime than the band regimes. So, we decompose the forward premium into a long-run trend and short-term filtered component. When the cubic models are in terms of the trends, the career-risk effect is dominant for the weak currencies, the market-friction and limit-to-arbitrage theories are favorable for the strong currencies. When the regressorsare the filtered components, the career-risk effect is unique for the weak currencies under the band regimes. To recognize extreme observations the strong floaters base on the trend components, while the weak floaters and band-regime currencies base on the filtered components.

Contrarian strategy and overreaction in foreign exchange markets

This paper investigates patterns to assist investors to forecast future exchange rate movements. We test for overreaction and underreaction examining exchange rate changes following excess 1-day fluctuations for currencies in two emerging (Turkey, Brazil) and two developed (US, UK) countries. Using euro as the base currency, we identify that the Turkish lira, the Brazilian real and the US dollar overreact, while the British pound underreacts. In the case of British pound, asymmetric responses and lack of volatility are two crucial factors to reject overreaction. Also, we find that contrarian strategy can be used in all currency markets for profitable investments.

World currency exchange rate cross-correlations

World currency network constitutes one of the most complex structures that is associated with the contemporary civilization. On a way towards quantifying its characteristics we study the cross correlations in changes of the daily foreign exchange rates within the basket of 60 currencies in the period December 1998–May 2005. Such a dynamics turns out to predominantly involve one outstanding eigenvalue of the correlation matrix. The magnitude of this eigenvalue depends however crucially on which currency is used as a base currency for the remaining ones. Most prominent it looks from the perspective of a peripheral currency. This largest eigenvalue is seen to systematically decrease and thus the structure of correlations becomes more heterogeneous, when more significant currencies are used as reference. An extreme case in this later respect is the USD in the period considered. Besides providing further insight into subtle nature of complexity, these observations point to a formal procedure that in general can be used for practical purposes of measuring the relative currencies significance on various time horizons.