Currency Spot Research Articles

Dynamic Hedging with Foreign Currency Futures in the Presence of Jumps

A dynamic hedging strategy based on a bivariate GARCH-jump model augmented with autoregressive jump intensity is proposed to manage currency risk. The GARCH-jump model, capable of capturing volatility clustering and leptokurtosis, provides a comprehensive description of the joint dynamics of the currency spot rate and the futures basis. We find significant common jump components in the currency spot rate and futures basis with jump sizes response symmetrical to futures basis changes. Our out-of-sample hedging exercises show optimal hedge ratios incorporating information from common jump dynamics substantially reduce the portfolio risk of foreign currencies.

ERM effects on currency spot and futures markets

The effects of the Exchange Rate Mechanism (ERM) of 1991–1993 on currency markets are examined. It is shown that the mechanism has led to a regime shift going from the 1980s to the 1990s. The floating exchange rates of the 1980s are associated with the forward premium puzzle (FPP) in spot markets. Furthermore, the futures–spot basis does have explanatory power on futures returns, which violates the expectations hypothesis. In the 1990s the FPP is diminished and uncovered interest parity holds in spot markets and futures returns cannot be explained by the basis. Therefore, the main contribution of this article is that the ERM has reduced currency risk premium volatility and thus validated the expectations hypothesis in both spot and futures markets.

Wavelet multiresolution analysis of high-frequency Asian FX rates, Summer 1997

Foreign exchange (FX) pricing processes are nonstationary: Their frequency characteristics are time dependent. Most do not conform to Geometric Brownian Motion (GBM), because they exhibit a scaling law with Hurst exponents between zero and 0.5 and fractal dimensions between 1.5 and 2. Wavelet multiresolution analysis (MRA), with Haar wavelets, is used to analyze these time and scale dependencies (self-similarity) of intraday Asian currency spot exchange rates. We use the ask and bid quotes of the currencies of eight Asian countries (Japan, Hong Kong, Indonesia, Malaysia, Philippines, Singapore, Taiwan, and Thailand) and, for comparison, of Germany for the crisis period May 1, 1998–August 31, 1997, provided by Telerate (U.S. dollar is the numéraire). Their time-scale-dependent spectra, which are localized in time, are observed in wavelet scalograms. The FX increments are characterized by the irregularity of their singularities. Their degrees of irregularity are measured by homogeneous Hurst exponents. These critical exponents are used to identify the global fractal dimension, relative stability, and long-term dependence, or long-term memory, of each Asian FX series. The invariance of each identified Hurst exponent is tested by comparing it at varying time and scale (frequency) resolutions. It appears that almost all investigated FX markets show antipersistent pricing behavior. The anchor currencies of the D-mark and Japanese Yen (JPY) are ultraefficient in the sense of being most antipersistent or “fast mean-reversing.” This is a surprising result because most financial analyst either assume neutral or persistent behavior in the financial markets, based on earlier research by Granger in the 1960s. This is a pedagogical paper explaining the most rational methodology for the identification of long-term memory in financial time series.

Forward premiums and market efficiency: Panel unit-root evidence from the term structure of forward premiums

A plausible explanation for cointegration among spot currency rates determined in efficient markets is the existence of a stationary, time-varying currency risk premium. Such an interpretation is contingent upon stationarity of the forward premium. However, empirical evidence on the stochastic properties of the forward premium series has been inconclusive. We apply a panel unit-root test – the Johansen likelihood ratio (JLR) test – to forward exchange premiums by utilizing cross-sectional information from their term structure. In contrast to earlier studies, the JLR test provides decisive and temporally stable evidence in support of stationary forward premiums, and therefore foreign exchange market efficiency, for six major currencies.

The Future of the Foreign Exchange Market

This paper addresses the future of the foreign exchange market using two organizing (and provocative) ideas. One pertains to the market’s institutional structure, the other to its information structure. The first organizing idea is that the structure of currency markets is driven primarily by the management of credit risk. This contrasts with drivers identified by micr ostructure theory (such as management of market risk, attenuation of asymmetric information, and entry barriers). The second organizing idea is that price variation in spot currency markets is driven primarily by dispersed information. This too contrasts with the orthodox view, under which exchange rates are determined from public information. Though provocative, these two ideas are vital to understanding this market’s future. Based on drivers of the market’s current structure, I propose three scenarios for future evolution. The scenario I consider most likely is one in which the current dealer structure is maintained through dealing banks’ crosssubsidizing their liquidity provision using gains from superior order flow information.

Trading rule profits in Latin American currency spot rates

The efficiency of foreign exchange markets has received extensive attention in the literature in recent years, especially with regard to technical trading. We extend the existing evidence on this topic by applying the moving average (MA) and channel (CH) trading rules to 13 Latin currencies to see if opportunities for profitable trading exist. Our results show that although not all of the Latin American currencies can be exploited through the use of trading rules that we use, there are some that appear amenable to our technical analysis. Specifically, the results suggest that MA trading rules are profitable for four currencies, namely the Brazilian real, the Mexican peso, the Peruvian new sol, and the Venezuelan bolivar. We further find that CH rules are profitable for the Brazilian real, the Mexican peso, and the Venezuelan bolivar. Our results suggest that due to differences in the statistical properties of exchange rates, some trading rules may be more suitable for certain types of currencies.

Wavelet Multiresolution Analysis of High-Frequency Asian FX Rates, Summer 1997

FX pricing processes are nonstationary and their frequency characteristics are time-dependent. Most do not conform to geometric Brownian motion, since they exhibit a scaling law with a Hurst exponent between zero and 0.5 and fractal dimensions between 1.5 and 2. This paper uses wavelet multiresolution analysis, with Haar wavelets, to analyze the nonstationarity (time-dependence) and self-similarity (scale-dependence) of intra-day Asian currency spot exchange rates. These are the ask and bid quotes of the currencies of eight Asian countries (Japan, Hong Kong, Indonesia, Malaysia, Philippines, Singapore, Taiwan, Thailand), and of Germany for comparison, for the crisis period May 1, 1998 - August 31, 1997, provided by Telerate (U.S. dollar is the numeraire). Their time-scale dependent spectra, which are localized in time, are observed in wavelet based scalograms. The FX increments can be characterized by the irregularity of their singularities. This degrees of irregularity are measured by homogeneous Hurst exponents. These critical exponents are used to identify the fractal dimension, relative stability and long term dependence of each Asian FX series. The invariance of each identified Hurst exponent is tested by comparing it at varying time and scale (frequency) resolutions. It appears that almost all FX markets show anti-persistent pricing behavior. The anchor currencies of the D-mark and Japanese Yen are ultra-efficient in the sense of being most anti-persistent. The Taiwanese dollar is the most persistent, and thus unpredictable, most likely due to administrative control. FX markets exhibit these non-linear, non-Gaussian dynamic structures, long term dependence, high kurtosis, and high degrees of non-informational (noise) trading, possibly because of frequent capital flows induced by non-synchronized regional business cycles, rapidly changing political risks, unexpected informational shocks to investment opportunities, and, in particular, investment strategies synthesizing interregional claims using cash swaps with different duration horizons.

The Intertemporal Relationship Between the Currency Spot Market and the Currency Option Market

This study examines the lead/lag relationship between currency option and currency spot markets for the Deutsche mark and the Japanese yen. Using intraday currency option transactions data for the year 1989 and applying a European type currency option pricing model, pair data series of the implied and the observed exchange rates are compiled. Causality tests are then employed to test the causal relation between the observed and the implied exchange rate changes. The results indicate that the currency spot market leads the currency option market by about ninety minutes.

A comprehensive look at the efficacy of technical trading rules applied to cross-rates∗

Moving average (MA) and channel rules (CH) are applied to ten spot cross-rates – AUD/JPY,GBP/JPY,CAD/JPY,DEM/GBP,DEM/ITL,DEM/JPY,DEM/CHF,CHF/GBP, and CHF/JPY – to examine whether opportunities for profitable trading exist. The results suggest that neither trasding rule is profitable. Overall, the results are consistent with those reported in Lee and Mathur ∗∗ ∗∗Lee C.I. and Mathur, I. (1996), Trading rule profits in European currency spot cross-rates, Journal of Banking and Finance, 20, 949–62. and in sharp contrast with the evidence from studies on dollar-denominated exchange rates. The costs of direct currency exchange through cross-rates and through indirect dollar-related transactions are also estimated. The savings related to direct cross-rate currency exchanges are estimated to range from 0.004% to 0.22%.

First and second order inefficiency in Australasian currency markets

The purpose of this paper is to present a modified test for common roots in which GARCH effects in the correlating combinations of residuals is accounted for. This procedure extends the multivariate testing framework by accounting for common volatility and allowing for this effect in the test statistics. The example provides evidence of first-and/or second-order inefficiency in the Australasian spot currency markets. Significant links are found between the Australian Dollar and other major currencies trading in Asia Pacific markets. The Australian Dollar in one of the top six traded currencies internationally and speculative activity is very strong.

Trading rule profits in european currency spot cross-rates

The moving average (MA) trading rule is applied to six European spot cross-rates — JY/BP, DM/BP, JY/DM, SF/DM, SF/BP, and JY/SF — to see if opportunities for profitable trading exist. The results suggest that MA trading rules are marginally profitable only for the JY/DM and the JY/SF cross-rates, while trading rules are not profitable for the other four cross-rates. Bootstrapping and out-of-sample tests provide similar results. Examination of subsamples characterized by central bank intervention do not produce different results. Computation of Box-Pierce statistics adjusted for heteroscedasticity show that daily returns for all six cross-rates are serially uncorrelated. Overall, the results suggests that cross-rates are sufficiently transparent to eliminate MA trading rule profit.

Efficient Selection of Insured Currency Positions: Protective Puts vs. Fiduciary Calls

We examine the empirical results from implementation of portfolio insurance strategies employing currency spot and futures options. Hypotheses are generated from Ogden and Tucker's (1988) generalizations concerning the relative values of American spot currency options and currency futures options. We find that protective puts using futures options are generally dominated by both protective puts that use options on spot currencies and by fiduciary calls on futures contracts. This suggests that the prices of puts on foreign currency futures contracts are too high, relative to foreign currency futures calls and to puts on spot currencies.

A note on weekday, intraday, and overnight patterns in the interbank foreign exchange and listed currency options markets

Transactions data are used to investigate returns patterns for close-to-close, close-to-open, and intraday long positions in spot currency (interbank) and currency put options (listed) for the years 1983 through 1988. Both trading-day and calendar-day hypotheses are investigated. Under the former, spot market returns are found to be significantly higher from Friday close to Monday close and from Friday close to Monday open. Under the calendar-day hypothesis, however, no significant close-to-close pattern emerges, and the Friday close to Monday open effect is reversed. Finally, spot (put) market returns are found to be significantly lower (higher) for Tuesday and Friday afternoons.

Risk Premia in Foreign Currency Futures

This paper tests the uncorrelatedness of increments of daily foreign currency futures prices and derives implications for risk premia based on a heteroscedasticity-robust variance ratio test. There is evidence suggesting the existence of a time-varying risk premia. Moreover, the results suggest that currency futures price is not an unbiased predictor of currency spot price on corresponding maturity date of currency futures contract. The paper also applies a heteroscedasticity-adjusted Box-Pierce Q test to the same data set for comparison.

Tests for a Systematic Risk Component in Deviations from Uncovered Interest Rate Parity

In the intertemporal asset pricing model, investments in spot foreign currencies involve time-varying risk proportional to the conditional covariance of the value of the position with the intertemporal marginal rate of substitution of domestic currency. We detect such risk premia in deviations from uncovered interest rate parity using weekly spot currency prices and Eurocurrency interest rates. Our tests use the conditional capital asset pricing model with a world equity index as benchmark to represent aggregate wealth.

The Relative Valuation of American Currency Spot and Futures Options: Theory and Empirical Tests

This study empirically tests contingent claims pricing models for American currency spot and futures options. Numerical analysis indicates that the difference in the model prices of spot and futures put (call) options (with the same exercise price and maturity) is, for a premium (discount) currency, positive and an increasing function of (a) the absolute dif? ference in the prices of the underlying spot and futures contracts and (b) the maturity of the options. Tests on British pound, Deutsche mark, and Swiss franc options indicate many violations ofthe ordinal pricing relationships noted above. Additional tests indicate that option prices are inconsistent with functional relationship (b) above. Most of the ob? served violations are sufficiently large to provide arbitrage profits net of transaction costs, assuming interest rates are constant and the Interest Rate Parity theorem holds continu? ously. Alternatively, both the violations and the inconsistent functional relationship may be due to violation of the assumption of constant interest rates.

Testing the rate forecasting consistency of major foreign currency futures

This paper examines the forecasting accuracy of currency futures markets in Canadian Dollars, British Pounds, Japanese Yen, German Marks, and Swiss Francs in predicting the actual spot rates that will exist in the spot market for these currencies. A second objective is to determine if the accuracy of the forecast is related to the time to maturity of the currency futures contract relative to the actual spot rate for that currency. The results indicate that the currency futures market appears to be a reasonably good forecaster of future currency spot rates.

Tests of an American Option Pricing Model on the Foreign Currency Options Market

This paper tests the ability of the American option pricing model proposed by Parkinson [18] or Mason [14] to explain the pricing of the foreign currency options traded on the Philadelphia Stock Exchange from February 28, 1983 to March 26, 1985. We find that the model underprices out-of-the-money options relative to at-the-money and in-the-money options. This relative underpricing is driven by an underpricing of out-of-the-money call options of short maturity. In addition, the degree of relative mispricing for most categories of options is shown to be a decreasing function of the time to maturity of the options. Longer maturity options appear to trade at similar levels of implied volatility whether they are in, at, or out of the money. Most of these biases appear consistent with the fact that the underlying spot currency rate follows a mixed jump diffusion process as described in [17].

THE HEDGING EFFECTIVENESS OF FOREIGN CURRENCY FUTURES

AbstractThis study provides an initial analysis of the hedging potential of the foreign currency futures markets. Numerous studies exist on the pricing efficiency and hedging effectiveness of the foreign currency forward markets, but little research exists on the foreign currency futures market. An adequate price history has only recently become available to carry out such an investigation. Minimum risk hedges and hedging effectiveness measures are presented for five currencies: the British pound, German mark, Canadian dollar, Japanese yen and Swiss franc. Analysis indicates the relative desirability of positions in futures contracts to minimize the risk of spot currency exposure. Results also show hedging effectiveness increases with the investment horizon.

Forward Exchange Price Determination in Continuous Time

The work of Black and Scholes [2] and Merton [4] suggests that analysis of hedged positions in a continuous time random walk model yields powerful insights into the valuation of financial securities. The present paper extends this methodology in a straightforward fashion to foreign exchange transactions. By adopting the device of hedging in a secondary market for forward currency contracts against a long position in spot currency, a simple statement of boundary conditions for the forward position can be detailed. This allows a direct solution of the continuous time valuation problem that yields the interest rate parity theory.