Emerging Market Currencies Research Articles

Quantifying the spillover effects of U.S. economic policy uncertainty on emerging market economies using GMM-PVAR model

This paper quantifies the spillover effects of economic policy uncertainty (EPU) in the United States on emerging market economies (EMEs). Using a generalized method of moments (GMM) estimation of a panel vector autoregression (PVAR) model on a dataset­ of 39 EMEs from 2005 to 2019, we find that increased U.S. EPU significantly raises the consumer price index (CPI) and negatively impacts the real GDP of these economies. Additionally, heightened U.S. EPU leads to a depreciation of emerging market currencies and a reduction in short-term interest rates. We employ a news-based EPU index developed by Baker et al. (2016) and conduct robustness checks using forward orthogonal transformation, an alternative EPU index, and by addressing the potential endogeneity of the oil price uncertainty (OPU) index. Our findings highlight the adverse effects of U.S. economic policy uncertainty on key macroeconomic variables in emerging markets, underscoring the importance of stable economic policies and robust institutions to mitigate these impacts.

U.S. Interest Rates and Emerging Market Currencies: Taking Stock 10 Years After the Taper Tantrum

In 2013, a shift in expectations of market participants for the timing of the tapering of the Federal Reserve's asset purchases, and its ramifications for normalization of U.S. monetary policy, led to sharp increases in longer-term U.S. Treasury yields and volatility in broader financial markets. The episode came to be known as the "taper tantrum" because the strong market reaction came in response to Federal Reserve communications that were largely consistent with market analysts' expectations.

ESTIMATED IMPACT OF UKRAINE WAR ON EXCHANGE RATE RISK OF MULTINATIONAL ENTERPRISES OPERATING IN EMERGING MARKETS

ABSTRACT Multinational enterprises (MNE) operating in emerging countries are exposed to various types of risk. Exchange rate risk is an important and anticipated part of MNE’s total risk exposure, with a variety of tools available to mitigate that risk. In this study, we focus on transaction exposure of cash flows in eight distinctive emerging market currencies and employ the Modified Value-at-Risk (MVaR) model to estimate the maximum one-period loss during a twelve-month period spanning pre- and during the Ukraine war periods. The predicted losses by MVaR are then compared to the ex-post results, to identify any differences in the pre-and during the Ukraine war periods and to determine the need for adjustments in hedging strategies by MNEs during similar global crises. The motive of this research is to understand the limitations of hedging and what can MNEs do to mitigate transaction exposure risk. The results provide insights into whether MNEs should hedge their currency risk or not. The Ukraine war did impact all firms globally, so this study is relevant and pertinent as firms plan theirs during the war growth. Keywords Exchange rate, transaction risk, value-at-risk, emerging markets, hedging, optimal portfolio

Are Exchange Rate Contagions Asymmetric? Evidence from Emerging Market Economies

ABSTRACT In view of increasing importance of emerging market currencies in the global foreign exchange markets and the growing concerns regarding the vulnerability of these currencies to global crises, we assess the connectedness of 16 emerging currencies by employing asymmetric domains of time and frequency spanning March 2011 to January 2022. We first notice bidirectional interconnectedness (both positive and negative) among three clusters of sampled exchange rates. The currency contagions follow divergent directions during crisis periods. During US debt selling crisis, there is a short-run negative contagion pointing to the appreciation of currencies. Following the Chinese financial market crisis, emerging market currencies demonstrated devaluation. There is long-run positive contagion (devaluation) in response to European Debt Crisis, Russian Ruble Crisis, Brazilian economic crisis, and Argentinian monetary crisis. The sampled exchange rates demonstrate negative long-run connectedness (appreciation) after COVID-19. The major transmitters to total connectedness are South Africa, Poland, and Mexico and major receivers include Thailand, the Philippines, Malaysia, India, Indonesia, and Egypt. In the long run, China is emerging as a significant transmitter. Our study draws significant policy and practical implications for regulators, investors, and financial market participants.

Foreign exchange market efficiency during COVID-19 pandemic

The main objective of this paper is to examine the efficiency of the foreign exchange (FX) markets before and during the turbulent periods surrounding the COVID-19 pandemic. Our efficiency tests are based on the Unbiasedness Forward Rate Hypothesis (UFRH). We use a pooled sample that contains 26 developed and emerging market currencies spanning the pre-COVID period (from November 30, 2018 to November 29, 2019), as well as the COVID period (from December 2, 2019 to November 30, 2020) as the key event which represents the time of tension. Our central finding in this paper is that FX market efficiency fails to hold during the COVID period, suggesting that the pandemic is a destabilizing event for the currency markets.

Deviations from covered interest parity in the emerging markets after the global financial crisis

In this paper, we focus on six emerging market economies to study the magnitude of systemic and persistent deviations from covered interest parity (CIP) using daily data between January 2010 and July 2018. We show the significant role of local factors, particularly credit and liquidity risk, in explaining sustained CIP deviations in these markets. Our findings suggest that the impact of credit risk on CIP deviations in emerging market economies may take two forms. In low-carry currencies, the well-known mechanism for credit risk operates so that the increase in credit risk exacerbates CIP deviations. Conversely, in high-carry currencies, the high usage of foreign exchange swaps makes swap rates react more than domestic rates, which causes CIP to decrease. We also present evidence that cost of illiquidity is an important driver to explain CIP deviations. We demonstrate that increased liquidity in emerging market currencies is not as large to prevent CIP deviations.

Does the Exchange Rate Respond to Monetary Policy in Mexico? Solving an Exchange Rate Puzzle in Emerging Markets

AbstractThis paper argues that the null or weak response of emerging market currencies to domestic monetary policy documented in the literature is the result of wide event windows. An event study with intraday data for Mexico shows that an unanticipated tightening appreciates the currency and flattens the yield curve, consistent with the evidence for advanced economies. With daily event windows, however, only the yield curve responds to monetary policy. Noise in daily exchange rate returns explains the lack of response of the currency. Such noise gives rise to a bias that declines after controlling for potential omitted variables.

Currency Momentum: An Emerging Market Issue?

Three main currency strategies have been established in the literature: carry, value, and momentum. We investigate momentum using data on 27 currencies (10 developed countries and 17 emerging markets). We find that momentum returns are driven by emerging market currencies, while the currencies of developed countries have no impact. An emerging market- specific dollar risk factor can partly explain these momentum returns. We carry out permutation tests and find support for our hypothesis that momentum returns are driven by emerging markets. However, we show that transaction costs reduce momentum returns considerably. We also show that the returns are time-varying and have been unattractive recently. The implications of this study for financial practitioners are to focus on emerging market currencies and optimise transaction costs when executing momentum strategies.

Practical Applications of Emerging Market Diversification Benefits: Stock Funds versus Currency Funds

1. Leonard L. Lundstrum 1. is a professor of finance in the College of Business at Northern Illinois University in DeKalb, IL. (llundstrum{at}niu.edu) In [ Emerging Market Diversification Benefits: Stock Funds versus Currency Funds ][1], from the Fall 2021 issue of The Journal of Wealth Management , Leonard Lundstrum of the College of Business at Northern Illinois University analyzes an investable emerging market currency strategy. He concludes that adding an emerging market currency fund to an otherwise well- diversified developed market portfolio adds an incremental diversification benefit. Adding emerging market equities to the same portfolio fails to achieve a similar benefit. [1]: https://doi.org/10.3905/jwm.2021.1.140

Up the stairs, down in the elevator? The asymmetric response of emerging market currencies to the global liquidity cycle

Abstract This paper assesses whether there is evidence of an asymmetric relationship between the global liquidity cycle and the currencies of developing and emerging economies (DEEs), a central tenet of the Minskyan interpretation of the exchange rate behaviour in these economies and the ‘financialisation in developing and emerging economies’ literature. We use a novel panel model technique that incorporates asymmetric components to fixed-effects regressions to check if there is evidence of such asymmetry. Our results suggest that capital flows, commodity prices and the VIX have a more substantial relationship with the currencies of DEEs during the retrenchment of the global liquidity cycle than during its expansionist phase. In other words, our results suggest that the currencies of DEEs take the stairs up and the elevator down.

Exchange Rate Volatility and Portfolio Flows : A State Dependent and Heterogeneous Relationship, Evidence from Emerging Market Currencies

Exchange Rate Volatility and Portfolio Flows : A State Dependent and Heterogeneous Relationship, Evidence from Emerging Market Currencies

Time-varying risk aversion and currency excess returns

This paper documents an economically significant risk premium associated with a currency’s sensitivity to time-varying risk aversion. Consequently, an investment strategy that takes a long (short) position in currencies with high (low) sensitivity to aggregate market risk aversion yields significantly positive excess returns. While advanced market currencies including the Euro, Yen and Swiss Francs dominate the short end of these portfolios with low sensitivity to risk aversion, emerging market currencies including the Brazilian Real, Mexican Peso and Turkish Lira are found to be the most sensitive currencies to risk aversion. The excess returns from the proposed strategy are significant even after controlling for systematic equity market risk factors as well as liquidity risk and cannot be explained by measures of economic conditions or uncertainty. Interestingly, the excess returns generated by the risk aversion-based strategy are found to have significant loadings on global momentum, suggesting possible commonality in the behavioral drivers of anomalies in the global equity and currency markets. The findings highlight the role of behavioral factors as predictor of currency excess returns with significant investment implications.

Dynamics of return and liquidity (co) jumps in emerging foreign exchange markets

We investigate the dynamics of return and liquidity (co) jumps for three of the most traded emerging market currencies vis-à-vis US dollar. Accordingly, an increase in the average bid-ask spread (realized volatility) significantly reduces the duration between consecutive return (liquidity) jumps, while liquidity and volatility only play a partial role on the duration between consecutive return-liquidity cojumps. There is also evidence of vicious return-liquidity spirals in views of the positive contemporaneous impact of liquidity jumps on volatility and return jumps on the bid-ask spread. Finally, scheduled macroeconomic news and central bank announcements increase the likelihood of both return and liquidity (co) jumps.

Emerging Market Diversification Benefits: Stock Funds versus Currency Funds

We examine the empirical evidence on the diversification benefits of adding investable emerging market currency fund exposure to a portfolio that is otherwise internationally-diversified across developed markets, and do likewise with an emerging market equity fund. We find that emerging market equity exposure does not offer diversification benefits, while, in contrast, emerging market currency funds do offer diversification benefits. These results are explained in part by the fact that a large proportion of the currency fund return variance is driven by idiosyncratic risk, and that proportion has not diminished over time. Furthermore, unlike emerging market equity returns, emerging market currency returns have not become more integrated over time with an internationally-diversified developed market portfolio. The results of a spanning test support these findings and suggest that currency funds favorably shift the efficient frontier. We conclude that emerging market currency funds are an effective investable vehicle to realize the diversification benefits of emerging market investing. <b>TOPICS:</b>Security analysis and valuation, currency, emerging markets, portfolio construction <b>Key Findings</b> ▪ Emerging market currency funds offer better diversification benefits than do emerging market equities. ▪ Emerging market currency fund returns are not becoming more integrated with developed market returns over time. ▪ The results of the diversification benefits analyzed using Sharpe ratios (Sharpe 1964) are consistent with the results of the benefits analyzed using spanning tests.

A filtered currency carry trade

In this paper, we document that the predictive capacity of forward discounts on future currency returns not only differs across currencies but also persists. We then propose a new currency carry trade strategy that relies on the differential predictive capacity of forward discounts. We find that the new strategy offers a significant amount of profit improvement over the conventional currency carry trade strategy. We also find that emerging market currencies provide relatively large profit opportunities. While both strategies show decreasing carry trade profits as FX markets get volatile, the relative outperformance of the new carry trade strategy tends to be found in stable periods but disappears in volatile periods. The superiority of the new carry trade relative to the conventional carry trade is robust to various specification changes.

Directional predictability in foreign exchange rates of emerging markets: New evidence using a cross-quantilogram approach

This study investigates the directional predictability of exchange rates in emerging markets. Using a cross-quantilogram model, we show that dependencies among emerging markets exchange rates are heterogeneous. Specifically, the Mexican peso, Brazilian real, and Turkish lira are leading emerging market currencies that provide hedging opportunities for currency investors. The structural dependencies across the pairs of exchange rates are evident at lag 1, and the relationships dissipate at longer lags. Secondly, the partial cross-quantilogram results indicate that oil is not a driving force of interrelationship among the exchange rates. Furthermore, the estimations of cross-quantile correlations from recursive subsamples reveal time-variant traits. If policymakers and financial regulators focus on comovements among emerging market currencies and distinguish net recipients from net transmitters in different environments, they can devise a surveillance system to adjust the market interdependence effects across emerging market foreign exchange rates. Therefore, they can promote the stability of emerging market currencies.

Internationalisation of emerging market currencies and original sin: Empirical evidence

AbstractThis article investigates the impact of the internationalisation of emerging market currencies on original sin, which is the inability of emerging countries to borrow abroad in local currency. The objective is to assess the role of measures of internationalisation on the currency structure of debt for a set of emerging market countries. We show the favourable impact of the internationalisation process on original sin for the period 2005–2018 using two different measures with a dynamic panel data empirical analysis. The main determinants are the foreign exchange (FX) turnover of the currencies, the economic size of the issuing country, and the Volatility Index (VIX). In this way, we highlight network effects between the functions of a currency. The tests also highlight the existence of inertia in the use of a currency for financial transactions. Finally, the results provide evidence on the role of derivative instruments in supporting the use of emerging market currencies in bond markets.

Variance risk premium and expected currency return: the story is different at the tails of the distribution

ABSTRACT This paper investigates the prediction power of variance risk premium of domestic currency over the currency return for five major emerging market currencies controlling after the impact of past exchange rate developments and asymmetries in the variance risk premium, and the dependence between variance risk premium and currency return at different quantiles. The OLS regression results show that higher (lower) variance risk premium leads appreciation (depreciation) of domestic currency against US Dollar and this relationship holds in after controlling asymmetries in the variance risk premium and past currency returns. Besides, the results don’t confirm an asymmetric effect of the variance risk premium and a linearly increasing effect of variance risk premium conditional on different quantiles of past currency return. Finally, quantile-on-quantile regression (QQR) results show that the negative association of variance risk premium and currency return reverse to be positive at the tails.

Conditional Skewness in Currency Markets

In this paper, I introduce the modeling of currency returns conditional on the interest rate differential and the real exchange rate under the assumption that FX returns are skew-t distributed. Beyond the well-known relationship between the currency risk premium and its risk factors, I document a negative effect of the interest rate differential and the real exchange rate on idiosyncratic skewness in a short-term horizon for a set of developed and emerging market currencies. The out-of-sample results reveal the evidence of the predictability of idiosyncratic skewness and the ability of conditional skewness to forecast currency risk premia at the country level. The risk factor based on conditional skewness is priced across carry trade portfolios and improves the understanding of the carry trade strategy returns. Flexible modeling of the return asymmetry and fat tails provides an accurate forecast of the value-at-risk and expected shortfall and contributes to the analysis of downside risk in the FX market.

Time-varying risk aversion and currency excess returns

This paper documents an economically significant risk premium associated with a currency’s sensitivity to time-varying risk aversion. Consequently, an investment strategy that takes a long (short) position in currencies with high (low) sensitivity to the aggregate market risk aversion yields significantly positive excess returns. While advanced market currencies including the Euro, Yen and Swiss Francs dominate the short end of these portfolios with low sensitivity to risk aversion, emerging market currencies including the Brazilian Real, Mexican Peso and Turkish Lira are found to be the most sensitive currencies to risk aversion. The excess returns from the proposed strategy are significant even after controlling for systematic equity market risk factors as well as liquidity risk and cannot be explained by measures of economic conditions or uncertainty. Interestingly the excess returns generated by the risk aversion based strategy are found to have significant loadings on global momentum, suggesting possible commonality in the behavioral drivers of anomalies in the global equity and currency markets. The findings highlight the role of behavioral factors as predictor of currency excess returns with significant investment implications.