High Exchange Rate Volatility Research Articles

Dynamics of Endogenous Business Cycles and Exchange Rate Volatility

This paper studies dynamics of endogenous business cycles and exchange rate volatility in a small open economy. Without market imperfections, domestic price and wage adjustments respond sluggishly to disequilibrium situations on real domestic markets while prices on international capital markets adjust instantaneously. The expectation formation mechanism under uncovered interest rate parity (UIP) induces a channel transmitting potential domestic real fluctuations into exchange rate fluctuations and vice versa. The interaction of the expectations feed back with the adjustment mechanism causes exchange rates to exhibit a higher volatility than other prices. The numerical analysis shows examples which confirm the typical empirically observed high volatility of nominal exchange rates compared with that of real/domestic variables.

Menu Costs and Nonlinear Reversion to Purchasing Power Parity Among Developed Countries

This paper examines the implications of menu cost models for the rate of reversion to purchasing power parity. Recent menu cost models (Ball and Mankiw, 1994) imply that higher inflation is correlated with more rapid price adjustment. This means that reversion to PPP may be more rapid, the greater the rate of inflation. In order to test this proposition, PPI-deflated real exchange rates are examined to see if the rate of reversion to PPP is a function of inflation. Another implication, due to both Delgado (1991) and Greenwald and Stiglitz (1989), is that higher exchange rate volatility is associated with slower rates of reversion. I find that both of these propositions hold in panel data, although the second proposition is less robust.

Why floating exchange rates fall: A reconsideration of the liquidity trap

In the international capital market, interest rates would seem to be natural shock absorbers for balancing currency risk associated with expected inflation or differential taxation. Under a floating exchange rate, however, short-term interest rates in each national money market behave as if caught in a liquidity trap. The problem arises because the domains for national monetary circulation remain somewhat disjoint even though the bond market is fully integrated internationally. The national rate of interest is ncapable of equilibriating the domestic money market on the one hand and the international bond market on the other. The result is excessively high exchange-rate volatility that distorts the flow of international commodity trade and causes cycles of inflation and deflation in open economies.

Creating and Pricing Hybrid Foreign Currency Options

M For more than ten years, foreign currency markets have been characterized by wide price changes. This high volatility of exchange rates has exposed corporate treasurers and international investors to a significant level of currency risk. Currency options markets have developed to provide new means of dealing with this growing risk. The purchaser of a foreign currency call (put) option has the right, but not the obligation, to buy (sell) a given amount of a foreign currency at a predetermined (strike) price at anytime on or before maturity date for an American option, or only at maturity for a European option. Currency options have been the subject of considerable professional and academic interest as well.1 Indeed, these are traded on several security exchanges throughout the world. A sizable over-the-counter market has also developed, offering a variety of specialized currency options. Among such specialized options are the so-called hybrid foreign currency options. These hybrid foreign currency options are based on some use of the put/call parity relation. For example, the exporting corporation buys a put and simultaneously sells a call from the bank so that the overall cost is less than the cost of a straight put, but then the exporter loses any potential gain from an appreciation of the foreign currency above the strike price of the call. Currency risk management has thus become a delicate compromise between flexibility, protection, and cost. The achievement of such a trade-off amounts to tailoring an instrument which perfectly matches the needs of the investor, conditional on his anticipations. Banks world-wide have been quite successful in marketing those hybrids, although theoretically they can be replicated by combinations of instruments traded on organized markets. A typical hybrid like the Cylinder We are grateful to the anonymous referees and Hans Stoll, Associate Editor, for their insightful comments. The usual caveat applies.