Global Foreign Exchange Research Articles

The Legal Underpinnings of the Global Foreign Exchange Market

The Legal Underpinnings of the Global Foreign Exchange Market

Online Appendix to "Heterogeneous Information Content of Global FX Trading"

This Appendix collects all tables and figures related to the paper. The paper studies the information content of trades in the world's largest over-thecounter market, the foreign exchange (FX) market. The results are derived from a comprehensive order flow dataset distinguishing between different groups of market participants and covering a broad cross-section of currency pairs. Our findings show that both the contemporary and permanent price impact are heterogeneous across agents, time, and currency pairs, supporting the asymmetric information theory. A trading strategy based on the permanent price impact capturing superior information generates high returns even after accounting for risk, transaction costs, and other common risk factors documented in the FX literature.

The Rise of the Dollar and Fall of the Euro as International Currencies

International currencies play important roles as foreign exchange reserves but are also most frequently used to denominate corporate and government bonds, bank loans, and import and export invoices. These currencies offer unrivaled liquidity, constituting large shares of the volume on global foreign exchange markets, and are commonly chosen as the anchors targeted by countries with pegged or managed exchange rate regimes. We provide evidence suggesting a recent rise in the use of the dollar, and fall of the use of the euro, with similar patterns manifesting across all these aspects of international currency use.

The Rise of the Dollar and Fall of the Euro as International Currencies

The modern notion of an international currency involves use in areas of international finance and trade that extend well beyond central banks' coffers. In addition to their important roles as foreign exchange reserves, international currencies are most frequently used to denominate corporate and government bonds, bank loans, and import and export invoices. These currencies offer unrivaled liquidity, constituting large shares of the volume on global foreign exchange markets, and are commonly chosen as the anchors targeted by countries with pegged or managed exchange rate regimes. In this short article, we provide evidence suggesting a recent rise in the use of the dollar, and fall of the use in the euro, with similar patterns manifesting across all these aspects of international currency use.

Can skewness predict currency excess returns?

This paper investigates whether the skewness of returns is informative about future currency excess returns. We first conduct portfolio-level analyses with and without control variables, such as volatility, liquidity and global foreign exchange (FX) volatility risk. Then, we run regressions at the currency level to examine the predictive ability of skewness. The empirical results indicate a positive and significant relationship between skewness and future currency excess returns. We then compare the skewness strategy with the traditional carry trade and find that skewness still matters after excluding the effects of the carry trade. Our empirical findings are robust to subsamples (emerging, non-Euro and Group of Twenty economies) and different business cycle states. Finally, we find that skewness strategies cannot be enhanced by considering information about currency regimes.

The Islamic gold dinar: a hedge against exchange rate volatility

Purpose The purpose of this paper is to investigate the ability of the Islamic gold dinar to hedge against two well-established foreign exchange (FX) risk factors namely, the dollar risk factor and global FX volatility innovations. Design/methodology/approach The paper uses a combination of the Markowitz (1952) portfolio optimization, visual data representations and the classic Fama-Macbeth (1973) two-pass procedure regressions. Findings The findings show that the Islamic gold dinar can serve as a hedge against market volatility, outperforms a diversified currency portfolio, and through its inclusions into the diversified currency portfolio, improve said portfolio’s ability to hedge against market volatility. Research limitations/implications Due to the spread of the sample, country-specific factors could not be taken into account. Practical implications The Islamic gold dinar is a cost-efficient, cost-effective, and Shariah-compliant instrument that provides a solid hedge for investors and/or firms that have financial positions denominated in foreign currencies. Should these investors or firms find it costly to maintain a dinar-only portfolio, including the dinar into their currency portfolios also provides the same benefit, albeit at a lower magnitude. Originality/value This study is timely as the Accounting and Auditing Organization for Islamic Financial Institutions has recently for the first time recognized gold as a Shariah-compliant investment. The findings of this study provide the first look as to how investors and firms can benefit through the use of the Islamic gold dinar in their risk management practices.

Modelling return and volatility spillovers in global foreign exchange markets

In this paper, we measure return and volatility spillovers in global foreign exchange (FX) markets using six most traded currency pairs in the world namely the aussie, cable, euro, gropher, loonie and swissie. We employ the Diebold and Yilmaz (2012) approach and consequently, we compute Total Spillover, Directional Spillover and Net Spillover indexes. We utilize daily data from Jaunary 01 1999 to December 31, 2014. We also carry out rolling sample analyses in order to capture secular and cyclical movements in global FX markets. We find evidence of interdependence among the major traded currency pairs based on the spillover indexes. In addition, return spillovers exhibit mild trends and bursts while volatility spillovers exhibit significant bursts but no trends. We also identify crisis episodes that seem to have influenced the recorded fluctuations in returns and volatilities of global FX markets. Our results are robust to the VAR lag structure, forecast horizon and rolling window width.

Divergent monetary policies and international dollar credit: Evidence from bank‐level data

AbstractThis paper uses a comprehensive and detailed bank‐level data set to study how the divergence of central bank balance sheet policy in the US vis‐à‐vis the euro area and Japan would affect the supply of international US dollar loans by global banks. Our empirical findings support the view that the contractionary effect of US monetary normalization on global dollar liquidity would be offset by an expansionary effect from continued supply of US dollar loans by euro area and Japanese banks. The net effect, however, is crucially dependent on the stability of global foreign exchange markets and investor perceptions of the default risks of global banks. Our findings show that there could be a significant contraction of the supply of international US dollar loans if and when the US monetary normalization coincides with a dislocation of the FX swap market and a rise of bank default risks. Our results are robust to alternative model specifications and different data sets.

Global price discovery in the Australian dollar market and its determinants

With Australia's growing importance in the global economy, the Australian dollar (AUD) has started to play a significant role in the global Foreign Exchange (FX) market. Using intraday trading data over the period of January 1999 to December 2013, we examine the determinants of price discovery in the AUD markets at two different time horizons. We find that the short-run determinants of price discovery include macroeconomic news, order flows and market state variables (i.e., return, volatility, trading volume and bid/ask spread). After controlling for the cross-region information flow and dynamic self-dependence, we find that more favorable market states and more unexpected order flows on macroeconomic news announcement days make a significant contribution to price discovery in the AUD market. Furthermore, we found that a higher level of market integration and consolidation contributes to price discovery process in the long-run.

Is Renminbi a (Truly) International Currency? An Evaluation Based on Offshore Foreign Exchange Market Trading Patterns

This article provides a new framework to evaluate the status of Renminbi internationalization. It proposes that the trading patterns of a currency in global foreign exchange market embody the currency’s position in the international monetary system. Based on foreign exchange trading data provided by CLS Group, the article constructs a ranking of major international currencies including Renminbi. It finds that Renminbi shares more similarities in foreign exchange trading patterns with the established global currencies like US dollar and Euro than with those regional currencies. The article also explores the policy implications that the new evaluation approach provides.

Currency co-movement and network correlation structure of foreign exchange market

We study the correlations of exchange rate volatility in the global foreign exchange(FX) market based on complex network graphs. Correlation matrices (CM) and the theoretical information flow method (Infomap) are employed to analyze the modular structure of the global foreign exchange network. The analysis demonstrates that there exist currency modules in the network, which is consistent with the geographical nature of currencies. The European and the East Asian currency modules in the FX network are most significant. We introduce a measure of the impact of individual currency based on its partial correlations with other currencies. We further incorporate an impact elimination method to filter out the impact of core nodes and construct subnetworks after the removal of these core nodes. The result reveals that (i) the US Dollar has prominent global influence on the FX market while the Euro has great impact on European currencies; (ii) the East Asian currency module is more strongly correlated than the European currency module. The strong correlation is a result of the strong co-movement of currencies in the region. The co-movement of currencies is further used to study the formation of international monetary bloc and the result is in good agreement with the consideration based on international trade.

Economic and Political Effects on Currency Clustering Dynamics

We propose a new measure named the symbolic performance to better understand the structure of foreign exchange markets. Instead of considering currency pairs, we isolate a quantity that describes each currency's position in the market, independent of a base currency. We apply the k-means clustering algorithm to analyze how the roles of currencies change over time, from reference status or minimal appreciations and depreciations with respect to other currencies to large appreciations and depreciations. We show how different central bank interventions and economic and political developments, such as the cap of the Swiss franc to the euro enforced by the Swiss National Bank or the Brexit vote, affect the position of a currency in the global foreign exchange network.

Bid-ask spread determination in the FX swap market: Competition, collusion or a convention?

Following a series of manipulation scandals in the global foreign exchange and money markets, recent lawsuits, regulatory reform proposals and bank compliance changes have explicitly targeted anti-competitive behaviour. By empirically investigating the determination of bid-ask spreads in foreign exchange swap markets, this paper addresses some contradictions where reciprocality, trust and conventions remain fundamental and logical. By doing so, the paper critically reflects upon the bid-ask spread in traditional market microstructure theory, the definition of the spread as a ‘component of price’ in antitrust law, and the policy implications in light of the recent regulatory investigations into financial benchmarks and OTC markets.

Unemployment fluctuations and the predictability of currency returns

We investigate whether unemployment fluctuations generate predictability in the cross-section of currency excess returns. We find that currencies with lower growth in the unemployment rate appreciate while currencies with higher growth in the unemployment rate depreciate. As a result, an investment strategy that involves investing in the former and short selling of the latter produces positive and sizable excess returns. Asset pricing tests show that the predictability is not driven by exposure to traditional risk factors such as global equity risk, global foreign exchange volatility risk, and downside risk but is related instead to an idiosyncratic unemployment risk.

The Confidence Trap: Japan’s Past Bubble and China’s Recent Bubble

ABSTRACTThis paper explores the origin of China’s recent credit and asset boom by comparing it with the Japanese bubble economy in the late 1980s by focusing on the asymmetric pattern of financial liberalisation under high savings. It argues that (1) both cases show a ‘confidence trap’ in that policy-makers of the government shared a complacent mindset that they can achieve the optimal mix of market liberalisation and repression, while believing that their political economic system is fundamentally different from others; (2) Such complacent confidence precipitated the supply-side driven financial reforms, in which both governments tried to diversify the credit channels of bank deposits by promoting non-bank financial intermediaries; (3) Exogenous shocks played a pivotal role in enforcing the government to take aggressive monetary easing and fiscal expansionary measures. But the Chinese case is different from the Japanese case in that (1) local politics has promoted a ‘too secure to fail’ situation in which rent-seeking activities are difficult to be detected, thus aggravating the hidden systemic risks; (2) China needs to liberalise its capital account with the more strengthened macroprudential regulatory governance, as the global foreign exchange markets have drastically changed from the period of the 1980s.

Causal relationship between the global foreign exchange market based on complex networks and entropy theory

The foreign exchange (FX) market is a typical complex dynamic system under the background of exchange rate marketization reform and is an important part of the financial market. This study aims to generate an international FX network based on complex network theory. This study employs the mutual information method to judge the nonlinear characteristics of 54 major currencies in international FX markets. Through this method, we find that the FX network possesses a small average path length and a large clustering coefficient under different thresholds and that it exhibits small-world characteristics as a whole. Results show that the relationship between FX rates is close. Volatility can quickly transfer in the whole market, and the FX volatility of influential individual states transfers at a fast pace and a large scale. The period from July 21, 2005 to March 31, 2015 is subdivided into three sub-periods (i.e., before, during, and after the US sub-prime crisis) to analyze the topology evolution of FX markets using the maximum spanning tree approach. Results show that the USD gradually lost its core position, EUR remained a stable center, and the center of the Asian cluster became unstable. Liang's entropy theory is used to analyze the causal relationship between the four large clusters of the world.

Development and Functioning of FX Markets in Asia and the Pacific

Global foreign exchange (FX) trading volume in traditional FX products and derivatives in Asia and the Pacific has expanded rapidly over the last fifteen years, more so than in other regions. Asian currencies also have experienced exceptional growth in offshore turnover, including non‐deliverable forwards (NDFs). Trading activity on this scale spread across many countries and currencies underscores the need for a well‐functioning infrastructure and exceptional risk management processes. While settlement risks are mitigated for the vast majority of turnover through systems like CLS Bank, the Asia Pacific region would benefit by having more countries and currencies become CLS enabled or tradable under other Payment versus payment (PVP) systems. Though less pronounced than during the global financial crisis, FX markets in the region experienced added turbulence during the “taper tantrum” period of 2013. High turnover currencies tended to depreciate more after taper announcements; though volatility rose more sharply in currencies with low turnover. The FX market is a prominent venue for carry trades that are subject to crash risk. While there is some evidence of herding behavior exacerbating this risk over the past decade, the measures calibrated more recently do not suggest exceptional crowding into carry trades ahead of the “taper tantrum” in 2013. At the same time, our measures of crowdedness for the carry trade show considerable variation over time. Making crowdedness measures publicly available might be advisable.

Countries of the Eurasian Economic Union in the Global Economy

Purpose: the aim of the paper was to assess the level of involvement of the Eurasian economic Union (hereinafter EAEC) into the global economy. Methods: methods of system and synthesis analysis, structural-logical, economic-statistical, comparative and retrospective analysis were used in the study. Results: the structure of the global economy as a range of functional subsystems was presented. The indicators of involvement of countries into the global economy for each functional subsystem were suggested. The levels measuring the range of involvement of the country in global economy for each functional subsystem were proposed. The level of engagement of Armenia, Belarus, Kazakhstan, Kyrgyzstan, Russia into the global economy for each functional subsystem was assessed. The value of the levels of involvement of the EAEC countries were summarized in the table. Conclusions and Relevance: the EAEC countries are characterized by a low level of involvement in the global economy for most of the functional subsystems. The greatest number of lowest values were concentrated in such subsystems as the global transnational production and the global monetary system. Low values of involvement levels were obtained in all countries in the global transnational production subsystem, which indicated a lack of development of the transnational production of the EAEC countries. Low values of involvement levels were received in the world monetary subsystem in all countries, except Russia, showed the average level of involvement, due to the presence of the share of the ruble in the total turnover of the global foreign exchange market for currency pairs in the year 2016. A set of the best values were obtained in the common information space subsystem, where all the countries except Kyrgyzstan, showed an average level due to criterion – percentage of individuals using the internet, instead of the criterion, reflecting the development of infrastructural capacity. Russia was characterized by a higher level, and Kyrgyzstan, by a lower level of involvement in the global economy compared to other countries of the EAEC.

Unemployment Fluctuations and the Predictability of Currency Returns

We investigate if unemployment fluctuations generate predictability in the cross-section of currency excess returns. We find that currencies with lower growth in the unemployment rate appreciate, while currencies with higher growth in the unemployment rate depreciate. As a result, the investment strategy that invests in the former and shorts the latter produces positive and sizable excess returns. This strategy improves the performance of the optimal portfolio of the currency investor. Asset pricing tests show that the predictability is not a compensation for traditional risk-factors, such as global equity risk, global foreign exchange volatility and downside risk, but instead relates to currency value and momentum. In addition, we find support for an explanation concerning limits to arbitrage in the foreign exchange rate market.

Assessing Role of Gold as World’s Reserve Currency in Terms of Uncertainty

Objectives: The research is aimed at extending the holistic theoretical concept of genesis and development of the global foreign exchange market. It also presents guidelines to reorganize the world monetary system, as well as a rationale for the author’s view of a place and a role of gold on the today’s world currency market (in terms of uncertainty). Methods/ Analysis: Considering the methodological issues within the examined problem, the authors were supported by principles of the modern economic theory. The research was based on the system analysis; specific problems were solved with the help of the comparative, statistical and graphical analyses, using ranking and clustering methods. Results: The paper has presented an analysis for the current situation with the reserve currency, the US dollar, and given ideas of its possible reorientation towards gold as a more stable reserve asset in the global financial and currency markets. The authors have concluded that in the current conditions in the global foreign exchange market, there is no alternative to the existing reserve currency, the US dollar, but there is an opportunity to return the gold or e-gold as a reserve currency or a currency unit of account as a basic element within the global monetary system. Novelty/Improvements: There are the authors’ views on the current state of gold in the world and national monetary systems; the possibility has been proven to return the functions of the world’s money and a single international payment instrument to gold.Keywords: Gold Exchange Standard, Gold Value Standard, Monetary Gold, World Monetary System