Currency Crashes Research Articles

On the role of interest rate differentials in the dynamic asymmetry of exchange rates

Motivated by the lack of empirical evidence in favour of the uncovered interest rate parity rule, we revisit the informational content of interest rate differentials (IRD) to explain daily exchange rates variations. Proposing a novel version of a GARCH model, we allow for the IRD to impact on the time-varying conditional asymmetry of the depreciation rate. We find IRD to be a significant factor for the Euro (EUR), the Swiss franc (CHF), the Swedish Krona, the Japanese Yen and the British Pound. These findings empirically support currency crash theories, suggesting that the larger the difference between interest rates, the more likely the high-yield currency appreciates on average but also exhibits greater risk of a large depreciation. Compared to random walk and buy-and-hold benchmarks, we document superior out-of-sample mean returns of a trading rule exploiting IRD information for EUR and CHF.

Fiscal Histories

The fiscal theory states that inflation adjusts so that the real value of government debt equals the present value of real primary surpluses. Monetary policy remains important. The central bank can set an interest rate target, which determines the path of expected inflation, while news about the present value of surpluses drives unexpected inflation. I use fiscal theory to interpret historical episodes, including the rise and fall of inflation in the 1970s and 1980s, the long quiet zero bound of the 2010s, and the reemergence of inflation in 2021, as well as to analyze the gold standard, currency pegs, the ends of hyperinflations, currency crashes, and the success of inflation targets. Going forward, fiscal theory warns that inflation will have to be tamed by coordinated monetary and fiscal policy.

Exchange rate dynamics with crash risk and interventions

An exchange rate model with crash risk is developed with the exchange rate confined in a wide moving band. A currency crash occurs when its exchange rate breaches a boundary. Using an asymmetric mean-reverting fundamental shock to incorporate intervention policy in the model, the log-normalised exchange rate follows a mean-reverting square-root process, which generates left-skewed exchange rate distributions consistent with outlier negative returns in carry trades. The exchange rates of nine major currencies against the US dollar can be calibrated according to the model, where the mean reversion in the exchange rate dynamic is negatively cointegrated with the risk reversals.

Sovereign Defaults and Currency Crashes: Insurance, Carry Trade, and Quanto

Sovereign Defaults and Currency Crashes: Insurance, Carry Trade, and Quanto

Currency Carry Trades and Global Funding Risk

We measure funding constraints in international currency markets by deviations in the covered interest rate parity. Our measure of funding risk is the standard deviation of the magnitude of the funding constraints. This funding risk measure appears to be driven by conditions in the financial sector in the low interest rate, so called carry trade short countries, oil price volatility, as well as by the actions of the main central banks. Although funding risk has been present throughout our sample, it becomes only relevant in currency carry trading after 2008, suggesting that investors’ funding constraints start binding at that time. We document evidence that since 2008 funding risk has affected the magnitude of currency carry trading activity, carry trade returns, correlation between carry long and short currencies, relative equity returns in carry trade long vs. short countries, and the economies of carry trade long countries measured through changes in industrial production. We develop a theory of currency markets under funding constraints that has several testable implications. For instance, as funding constraints start to bind, our theory predicts that both the investment and funding currencies drop relative to a safe asset. This result is observable also in our empirical analysis, when we proxy for the safe asset with gold. In line with theory, funding risk forecasts currency crashes in the carry trade long and short countries.

International Capital Flows and Extreme Exchange Market Pressure: Evidence from Emerging Market Economies

In response to the currency crises in the emerging market economies (EMEs) during the 1990s, earlier studies tended to put emphasis on identifying and explaining currency crash, which is an extreme event mostly associated with massive capital reversals. After the 2008 global financial crisis, the focus shifted towards enormous capital inflows which have put a sharp appreciation pressure on domestic currency and inflated a large housing and construction bubble. In this paper, we examine the foreign exchange instabilities of a group of EMEs between 1995Q1 and 2019Q4 using the exchange market pressure (EMP) index by taking into considerations both extreme positive and negative episodes. The identification of tail observations is carried out under the framework of Extreme Value Theory (EVT) to handle asymmetric and heavy-tailed data. A panel multinomial logit model is used to explore whether the predictors differ between extreme positive and negative EMP events. Our findings show that (1) there is asymmetry in the EMP distributions, where the occurrence of currency crises is more frequent than excessive appreciations in most EMEs, (2) portfolio and credit flows are significant predictors to both extreme events, and (3) by distinguishing the residency of capital flows, foreign credit flow is the key factor that contributes to the devaluation pressure in the EMEs.

Interest Rate Differentials and the Dynamic Asymmetry of Exchange Rates

We propose a unified econometric strategy to revisit the informational content of interest rates differentials (IRD) for predicting exchange rates. The novelty of our approach consists in allowing for a time-varying asymmetry component in the conditional distribution of the depreciation rate, therefore explicitly modeling the link between interest rates and the likelihood of a depreciation. To assess the economic significance of IRD as a predictor, we derive a directional forecasting procedure from our model and apply this technique to daily exchange rates of the Euro and the Swiss Franc. We document in-sample and out-of-sample performances significantly superior to benchmark models, both in terms of sign forecasts and trading profits. Overall, we find the dynamic asymmetry component to be driven by interest rate differentials, but also by general uncertainty and past unexpected shocks. These findings empirically confirm currency crash theories for recent time periods, suggesting that the larger the difference between interest rates, the more likely the high yield currency appreciates but also exhibit larger depreciation risks.

Interest Groups, Policy Responses to Global Shocks, and the Relative Likelihood of Currency Crashes Versus Banking Crises

Shocks to global interest rates or risk cause capital outflows for countries outside the core of the global financial system. These outflows lead to downward pressure on exchange rates and financial sector stress, in addition to having general contractionary effects. To defend the exchange rate, the appropriate internal response is a fiscal/monetary contraction. To maintain full employment and financial stability, the appropriate internal response is fiscal/monetary expansion. The contradiction in these policy responses implies policymakers prioritize hitting either internal or external targets after these shocks; but how do they decide? Using a fixed effects model and data from 100 emerging market and developing economies from 1990 to 2012, we show that the relative sensitivity of interest groups to these policy responses influences which response occurs. We find some evidence that this effect is stronger in the presence of more political-institutional constraints. Using a strategic probit model, we also find some evidence that this policy response influences the relative likelihood of banking crises versus currency crashes after these global shocks.

Exchange Rate Solutions With Currency Crashes

We present an exchange rate model in which a currency’s exchange rate is confined in a wide moving band and a currency crash occurs when the rate breaches the lower boundary. A solution is derived from the standard log exchange rate equation for the model with a smooth-pasting condition at the lower boundary. Using an asymmetric mean-reverting fundamental shock, the solution shows the exchange rate follows a mean-reverting square-root process, which is quasi-bounded at the boundary, and generates left-skewed exchange rate distributions consistent with empirical observations. The probability leakage for the exchange rate across the boundary increases with a weakened mean-reverting force for the exchange rate, suggesting an increase in currency crash risk. The empirical results show the exchange rates of nine major currencies against the US dollar can be calibrated according to the model, where the mean reversion is negatively cointegrated with the risk reversals in currency option markets, as expected by the model, and are consistent with the positive relationship between currency crash risk and risk reversals. The leakage condition for breaching the lower boundaries was met during the 2008 global financial crisis when most of the currencies were under the disaster shock.

Do Interest Groups Influence the Relative Likelihood of Banking Crises Versus Currency Crashes?

Do Interest Groups Influence the Relative Likelihood of Banking Crises Versus Currency Crashes?

Most Speculative Attacks Do Not Succeed: Currency Crises and Currency Crashes

While there has been considerable research on currency crises, relatively little attention has been given to whether they are successful or not. We investigate this question for a set of 32 emerging market economies for the period 1980–2014. In the literature, many different measures of currency crises have been used, but almost all use some variants of exchange market pressure indices that look at changes in exchange rates, international reserves, and often also interest rates. These vary mainly in their specific specifications such as how to weigh the different variables. Therefore, to check the robustness of our results we use six different specifications. A second type of measure is also sometimes used. These focus only on large depreciations of exchange rates. While often called measures of currency crises they are really only measures of currency crashes. We thus take this approach as a measure of successful attacks. Using a wider range of thresholds than studies such as Lavean and Valencia’s, a well-known dataset of different types of financial crises, we still find that the vast majority of speculative attacks are not successful.

The Chilean peso exchange-rate carry trade and turbulence

In this study we provide evidence regarding the relationship between the Chilean peso carry trade and currency crashes of the peso against other currencies. Using a rich dataset containing information from the local Chilean forward market, we show that speculation aimed at taking advantage of the recently large interest rate differentials between the peso and developedcountry currencies has led to several episodes of abnormal turbulence, as measured by the exchange-rate distribution’s skewness coefficient. In line with the interpretative framework linking turbulence to changes in the forward positions of speculators, we find that turbulence is higher in periods during which measures of global uncertainty have been particularly high.

Hawkes processes for forecasting currency crashes: Evidence from Russia

We consider models for predicting shocks in a foreign exchange market that take into account the endogenous nature of such crashes on the basis of the Hawkes processes. The intensity of the Hawkes processes depends on previous events that allow modeling the clustering effect and self-exciting behavior of returns after the crash. The models were tested on the USD/RUB currency pair.

Output Recovery After Currency Crises

This study examines the shape and dynamics of output recovery following currency crises characterized by currency crashes or large reserve losses. Our estimation allows output to follow U, V and L-shaped paths following each type of currency crises. The results indicate that output recovery after currency crises is, on average, V-shaped. In addition, currency crashes initially lead to a decline in output, but the output fully recovers to its non-crisis level within three years. Currency crises characterized by large reserve losses lead to a smaller initial output cost, but a larger decline in output in the long run.

The output effect of gross foreign investment reversals

A large literature links currency crashes and reversals in a country’s net external borrowing to output losses. In this article, we find that contractions in the stock of gross foreign claims on a country—a phenomenon we call gross foreign investment reversals (GIRs)—are also associated with output declines. GIRs are specially harmful during currency, current account, and sudden stop crises in emerging markets. Instrumental variables estimation suggests that this relationship is causal, running from GIR to output. Meanwhile, financial development and stocks of foreign assets can buffer emerging markets against the negative output effects of GIR. Jointly these findings suggest that changes in the composition of the current account, and not just its level or rate of change, can have first-order output effects. Thus, it may be important for future research to identify the determinants of GIR, a subject we only briefly touch on.

Sudden Stops and Currency Crashes

AbstractThis paper investigates which factors determine whether sudden stops in international capital flows are followed by a currency crash using data for 85 economies in the period 1980–2012. An event study approach is used for an 11‐year window around the crises for nine potential explanatory variables. In addition, the paper estimates discrete‐choice panel models. The results suggest that low trade openness, shallow financial markets, and current account imbalances increase the likelihood that a sudden stop will be followed by a currency crash. Moreover, it is established that the impact of these factors differs across different exchange rate regimes.

Sovereign Risk and Currency Returns

We empirically investigate the relation between currency excess returns and sovereign risk, as measured by credit default swap (CDS) spreads. An increase in a country’s CDS spread is accompanied by a contemporaneous depreciation of its exchange rate as well as an increase of its currency volatility and crash risk. The link between currency excess returns and sovereign risk is mainly driven by exposure to global sovereign risk shocks and also emerges in a predictive setting for currency risk premia. Sovereign risk forecasts excess returns to trading exchange rates, volatility and skewness, and is strongly priced in the cross-section of currencies. Moreover, we find that sovereign risk accounts for a large share of carry trade returns, and that carry and momentum strategies generate high (low) returns across countries with high (low) sovereign risk.

Early warning systems for currency crises: A multivariate extreme value approach

We apply extreme value theory to assess the tail dependence between three currency crisis measures and 18 economic indicators commonly used for predicting crises. In our pooled sample of 46 countries in the period 1974–2008, we find that nearly all pairs of variables are asymptotically independent: in the limit, extreme values of economic indicators are not followed by severe currency crashes. Our findings may explain the poor performance of existing early warning systems for currency crises. However, we do find that economic variables with stronger extremal association with the exchange rate have better crisis prediction performance, both in-sample and out-of-sample.

Modelling Currency Crises in Nigeria: An Application of Logit Model

Currency crises inflict significant social and economic costs on economies that have suffered its occurrence. Thus, statistical models have been developed over the years to construct reliable early warning systems as part of strategies for preventing or reducing the devastating effects of such crises. To the knowledge of this study, no recent work has been done in this regard with respect to Nigeria, especially following the 2008/09 global financial crisis. Using a logit model, this paper estimates the probabilities of currency crises in Nigeria as a logistic function of selected macroeconomic variables. Particularly, it provides answer to the question of whether real exchange rate misalignment propels currency crises. The empirical investigation used quarterly data for the period 2000Q1 to 2012Q4. Model results show that the likelihood of currency crisis in Nigeria increases when the real exchange rate is misaligned; the exchange rate is volatile; oil price declines; debt/GDP ratio increases; and the current account balance to GDP ratio declines. Real exchange rate misalignment has overarching influence on the tendency for currency crash during the estimation period. The paper therefore recommends regular assessments of the value of the Naira exchange rate vis-a-vis its equilibrium level with a view to implementing appropriate policy responses to arrest or avoid prolonged and substantial misalignment. Since all the variables entered the equation in their one period lag, the estimated model constitutes a reliable early warning system to policy makers on the likelihood of impending currency crisis in the country.

The IMF, Domestic Public Sector Banks, and Currency Crises in Developing States

The stabilization programs of the International Monetary Fund (IMF)—which are often designed to prevent currency crashes and promote exchange rate stability—frequently fail to prevent currency crises in program-recipient developing countries. This leads to the following puzzle: when do IMF programs fail to prevent currency crises in developing states that turn to the Fund for assistance? We suggest that the likelihood that a currency crisis may occur under an IMF program depends on the market concentration of public sector banks in program-participating developing countries: the higher the market concentration of public banks in a program recipient nation, the more likely that the IMF program will be associated with a currency crisis. Specifically, if the market concentration of public banks in a program-participating developing country is high, then banks will compel the government to renege on its commitment to implement banking sector reforms. This induces a financial panic among investors that leads to a currency crisis. Statistical tests from a sample of developing countries provide robust support for our hypothesis.