Spot Exchange Research Articles

Exchange Rates and Liquidity Risk

I use Forex trading data to study how risks associated with the lack of liquidity contribute to the dynamics of 17 spot exchange rates through their time-varying contributions to risk premia. I find that liquidity risk matters. All the foreign exchange risk premia compensate investors for exposure to liquidity risk; and, for many currencies, exposure to liquidity risk appears to be more important than exposure to the traditional carry and momentum risk factors. I also find that variations in the price of liquidity risk make economically important contributions to the behavior of individual foreign currency returns: they account for approximately 34%, on average, of the variability in currency returns compared to the contribution of approximately 8% from the prices of carry and momentum risk.

Spoofing and pinging in foreign exchange markets

This paper investigates the susceptibility of foreign exchange (FX) spot markets to limit order submission strategies that are either intended to create a false impression of the state of the market (‘spoof orders’) or to extract hidden information from the market (‘ping orders’). Using a complete limit order book dataset from Electronic Broking Services (EBS), our findings suggest that spoofing is more likely to succeed in liquid markets, or on primary electronic trading platforms. Pinging, by contrast, might be more prevalent in illiquid markets, or on secondary electronic trading platforms.

What does currency order flow tell about spot exchange rates of Asian emerging markets?

This study investigates the role of currency order flow in explaining the emerging Asian markets' exchange rates relying on linear and nonlinear modeling. The daily currency order flow of the US dollar relative to the nine important Asian currencies is constituted and explored with the respective exchange rates. First, we find that order flow affects the spot exchange rate positively for the sampled Asian currencies which indicates that the buying pressure of the US dollar depreciates Asian currencies. Second, the effect of order flow is asymmetric which explains that a surge and a fall in order flow have different effects on the exchange rate. This study unlocks the contribution of the market microstructure research where the asymmetries improve the power to explicate exchange rates. The nonlinear model forecasting performance validates this stance.

MACROECONOMIC FACTORS AND THEIR INFLUENCE ON THE VISEGRAD GROUP EXCHANGE RATES

The paper analyzes the effects of macroeconomic development on exchange rates and aims to point out indicators with a significant impact on the Visegrad Group's domestic currencies. Steep changes causing the Visegrad Group’s currencies to either appreciate or depreciate against the US dollar may result in higher risks for investors and even deteriorate the competitiveness of the particular country. The paper presents several macroeconomic indicators and their influence on four currencies, namely the Czech crown, Hungarian forint, Polish zloty and the Euro. As the Slovak Republic introduced the Euro as its official currency, the paper also analyzes it's impact on the common currency of the Eurozone. To emphasize international competitiveness, the research apart from traditional economic indicators, serving as a focal point in theories for exchange rate determination, incorporated economic complexity and corruption score as well. The findings indicate that during the period between 2000 to 2017, the two common indicators i.e. total reserves and corruption played the key role in determining the year-end spot exchange rates of the Czech crown, Hungarian forint and the Polish zloty. Besides corruption score, economic complexity serves as another significant indicator merely influencing the direction of the Euro's and the Zloty’s Dollar exchange rate movement. The last section compares the results of the OLS analyses for each country and verifies their accuracy through robust regressions. Overall, the model for the Czech crown represents the highest accuracy, regarding its predictive ability.

Spot exchange rate volatility, uncertain policies and export investment decision of firms: a mean-variance decision approach

This paper studies characteristics of optimal investment decisions of risk-averse firms who engage in exports under two types of risks: endogenous and background risks. While endogenous risk arises from the fluctuations in spot exchange rate and affects directly the profit of an exporting firm, background risk arises from uncertain changes in firm- and industry-specific domestic and foreign policies. We propose a mean-variance decision-theoretic model to trace out impact of perturbations in the distributions of these uncertainties on the optimal investment strategy. A testable empirical model is derived and applied to a panel of 840 exporting Indian manufacturing firms for the period 1995–2015. Our results suggest that Indian manufacturing exporters depict decreasing absolute risk aversion and that firms’ risk preferences are prone to variance vulnerability.

Counterparty Credit Limits: The Impact of a Risk-Mitigation Measure on Everyday Trading

ABSTRACT A counterparty credit limit (CCL) is a limit that is imposed by a financial institution to cap its maximum possible exposure to a specified counterparty. CCLs help institutions to mitigate counterparty credit risk via selective diversification of their exposures. In this paper, we analyse how CCLs impact the prices that institutions pay for their trades during everyday trading. We study a high-quality data set from a large electronic trading platform in the foreign exchange spot market that allows institutions to apply CCLs. We find empirically that CCLs had little impact on the vast majority of trades in this data set. We also study the impact of CCLs using a new model of trading. By simulating our model with different underlying CCL networks, we highlight that CCLs can have a major impact in some situations.

Trade Mis-Invoicing Between India & USA: An Empirical Exercise

India shares its majority of international trade with the United States of America. But a huge amount of discrepancy is frequently observed in the recorded bilateral trade statistics between these two countries. The main reasons are caused by several restrictions prevailing on the account of international trade in India. Export is found to be under-reported consistently whereas import data shows both over and under mis-invoicing in a periodic swing. This paper focuses on the determinants of this data fabrication with the help of empirical exercises. Several macroeconomic policy variables are taken to build up an econometric model and are tested statistically with the help of time series econometrics. Among all, relative interest rate plays the most important role to influence export and import mis-invoicing, followed by spot exchange rate and forward exchange rate. The exercise also finds a uni-directional causal relationship from import mis-invoicing of a period to export mis-invoicing of the next period. JEL Codes: C10, C13, C61, F13, F14, F21, K42

Exchange Rates and Liquidity Risk

I use Forex trading data to study how risks associated with the lack of liquidity contribute to the dynamics of 17 spot exchange rates through their time-varying contributions to risk premia. I find that liquidity risk matters. All the foreign exchange risk premia compensate investors for exposure to liquidity risk; and, for many currencies, exposure to liquidity risk appears to be more important than exposure to the traditional carry and momentum risk factors. I also find that variations in the price of liquidity risk make economically important contributions to the behavior of individual foreign currency returns: they account for approximately 34 percent, on average, of the variability in currency returns compared to the contribution of approximately 8 percent from the prices of carry and momentum risk.

Price Discovery in the United States Dairy Industry

Abstract The organized Exchange spot (cash) cheese market is a private industry institution that has historically performed a primary price discovery function in the U.S. dairy industry. In addition to affecting cheese prices in contract cheese market, the Exchange spot cheese prices have influenced prices paid for milk at the farm level that are set within the system of Federal Milk Marketing Orders (FMMOs). The effects that the Exchange spot cheese market has on FMMOs milk pricing attract increased attention in light of the recent concerns about increasing milk price volatility and its effect on the dairy farm profitability. While the design of milk pricing within FMMOs has evolved over the last three decades, the effects of the Exchange spot cheese prices on FMMOs milk pricing have intensified. The research analyzes the conduct and performance of the Exchange spot cheese market during three FMMOs milk pricing regimes (Minnesota-Wisconsin price regime, Basic Formula Price and modern Multiple Component Pricing regime), with a particular focus on the Exchange spot cheese price behavior.

Modern Application of Bai` al-Sarf (Currency Exchange) From Maqasid Al-Shari’ah Perspective: A Scoping Review

Bai’ al-sarf widely known as currency exchange is an important sale contract both in classical and contemporary world. This scoping review looks into the objectives behind the rulings set by the Shari’ah for this sale contract. These objectives are sorted out from the commentaries of the hadith and the deliberations of the jurists through textual analysis method. Some of the modern applications such as T+2 and Islamic Foreign Currency Exchange (FX) Swap structures are briefly juxtaposed against the objectives of bai’ al-sarf we discovered. Objectives of Shari’ah rulings in spot exchange is to avoid falling into the sale of debt against debt (al-kali bi al-kali), prevention of payment delay by one of the counter parties, prevention of conflict between the counter parties, and last not least to avoid falling into exchange contracts that will induce riba. Keywords: Bai’ al-sarf, currency exchange, spot seizing (al-taqabud fi al-majlis), equal counter-values (al-tamathul), sad bab al-niza’ (closing the door of conflict), riba.

Can country-specific interest rate factors explain the forward premium anomaly?

The forward premium anomaly refers to the fact that changes in spot exchange rates are negatively related to interest rate differentials between home and foreign countries, which is contrary to the predictions of the uncovered interest rate parity (UIRP). We propose a regression model of the interest rate differentials across countries (known as carry trade) adjusted for a time-varying exchange rate risk premium which can explain the anomaly and provide forecasts of exchange rate changes in accordance to the theory. The proposed model is based on estimates of the exchange rate risk premium implied by a simple and empirically attractive two-country affine term structure model with global and local factors. We also show that the forecasting power of the model compares favorably to the random walk model of exchange rates, considered as benchmark in the literature.

Predictability and pricing efficiency in forward and spot, developed and emerging currency markets

We study the predictability of forward and spot exchange rates of currencies of emerging and developed economies from 1994 to 2016. Our purpose is to shed light on the efficiency of currency markets and how and why it has evolved over this time. For the currencies of emerging economies, our analysis of rates of return on forward contracts finds some evidence of excess-predictability, especially in the earlier parts of the sample period, consistent with the view that this portion of the foreign exchange market has only become efficient in recent times. When we turn our attention to excess-returns computed from spot exchange rates and spot interest rates, however, we find much less predictability. In particular, over our full sample period, we find no evidence of excess-predictability, in contrast with the results reported by Hsu et al. (2016) but in agreement with Kuang et al. (2014). The different predictability of spot excess-returns and rates of return on forward contracts is a manifestation of the widespread violation of covered interest parity which emerged with the onset of the 2008 financial crisis.

Futures crude oil prices as predictors of spot prices: lessons from the foreign exchange market

Thanks mainly to the work of Post Keynesian economists, it is no longer universally accepted that the forward exchange rate is an accurate, unbiased and efficient forecaster of the spot exchange rate. However, the proposition that futures prices of crude oil can be used to forecast spot prices seems to be accepted without much scrutiny. This proposition is challenged both theoretically and empirically, suggesting instead that futures prices have nothing to do with forecasting. Since spot and futures prices are related contemporaneously, futures prices are as good or as bad forecasters as spot prices, in which case it is not sound to use the futures price as a forecaster and the spot price as a benchmark. The results show that spot and futures prices are not as good forecasters as they are portrayed to be. While futures prices produce small forecasting errors, because they are related contemporaneously to spot prices, they fail to capture turning points and exhibit signs of biasedness and inefficiency. Adjusting the random walk and the unbiased efficiency equations, by including a time-varying risk premium or a drift factor, does not make the models better in terms of predicting turning points.

The discontinuation of the EUR/CHF minimum exchange rate: information from option-implied break probabilities

Abstract We derive risk-neutral probability densities for future euro/Swiss franc exchange rates as implied by option prices. We find that the credibility of the Swiss franc floor decreased somewhat as the spot exchange rate approached the lower bound of 1.20 CHF per euro. We also compare the forecasting performance of a random walk benchmark model with an error-correction model (ECM) augmented with option-implied break probabilities of breaching the currency floor. We find some evidence that the augmented ECM has an informational advantage over the random walk when using one-month break probabilities. But we find that one-month option-implied densities cannot predict the entire range of exchange rate realizations.

Business Cycles and the Cross-Section of Currency Returns

We find a strong link between currency excess returns and the relative strength of the business cycle. Buying currencies of strong economies and selling currencies of weak economies generates high returns both in the cross section and time series of countries. These returns stem primarily from spot exchange rate predictability, are uncorrelated with common currency investment strategies, and cannot be understood using traditional currency risk factors in either unconditional or conditional asset pricing tests. We also show that a business cycle factor implied by our results is priced in a broad currency cross section.

Business cycles and currency returns

We find a strong link between currency excess returns and the relative strength of the business cycle. Buying currencies of strong economies and selling currencies of weak economies generates high returns both in the cross-section and time series of countries. These returns stem primarily from spot exchange rate predictability, are uncorrelated with common currency investment strategies, and cannot be understood using traditional currency risk factors in either unconditional or conditional asset pricing tests. We also show that a business cycle factor implied by our results is priced in a broad currency cross section.

IMPACT OF EXCHANGE RATE DERIVATIVES ON STOCKS IN EMERGING MARKETS

This paper investigates the effect of derivatives on the relationship between the foreign exchange rate and the stock market. A theoretical model is used to extend the understanding of that relationship. Also, the model is tested with an empirical analysis using the GMM strategy for the Mexican and Brazilian stock markets for the period 2007 to 2019. Findings reveal that in addition to the spot exchange rate, exchange rate futures explain the currency exposure, wherein the derivative effect is the most prominent. The result implies that both risk sources should be considered in the implementation of risk management or macroeconomic policy. The theoretical results are extended by applying them to international portfolio management, proposing a strategy to mitigate foreign exchange exposure with derivatives. This study contributes to the literature by explaining why the minimum variance hedge ratio plays an essential role in the foreign exchange rate and stock market nexus.

Maximum Likelihood Estimation of Continuous-time Diffusion Models for Exchange Rates

Five diffusion models are estimated using three different foreign exchange rates to find an appropriate model for each. Daily spot exchange rates expressed as the prices of 1 euro, 1 British pound and 100 Japanese yen in US dollars, respectively denoted by USD/EUR, USD/GBP, and USD/100JPY, are used. The maximum likelihood estimation method is implemented after deriving an approximate log-transition density function (log-TDF) of the diffusion processes because the true log-TDF is unknown. Of the five models, the most general model is the best fit for the USD/GBP, and USD/100JPY exchange rates, but it is not the case for the case of USD/EUR. Although we could not find any evidence of the mean-reverting property for the USD/EUR exchange rate, the USD/GBP, and USD/ 100JPY exchange rates show the mean-reversion behavior. Interestingly, the volatility function of the USD/EUR exchange rate is increasing in the exchange rate while the volatility functions of the USD/GBP and USD/100Yen exchange rates have a U-shape. Our results reveal that more care has to be taken when determining a diffusion model for the exchange rate. The results also imply that we may have to use a more general diffusion model than those proposed in the literature when developing economic theories for the behavior of the exchange rate and pricing foreign currency options or derivatives.

Maximum Likelihood Estimation of Continuous-time Diffusion Models for Exchange Rates

Five diffusion models are estimated using three different foreign exchange rates to find an appropriate model for each. Daily spot exchange rates expressed as the prices of 1 euro, 1 British pound and 100 Japanese yen in US dollars, respectively denoted by USD/EUR, USD/GBP, and USD/100JPY, are used. The maximum likelihood estimation method is implemented after deriving an approximate log-transition density function (log-TDF) of the diffusion processes because the true log-TDF is unknown. Of the five models, the most general model is the best fit for the USD/GBP, and USD/100JPY exchange rates, but it is not the case for the case of USD/EUR. Although we could not find any evidence of the mean-reverting property for the USD/EUR exchange rate, the USD/GBP, and USD/ 100JPY exchange rates show the mean-reversion behavior. Interestingly, the volatility function of the USD/EUR exchange rate is increasing in the exchange rate while the volatility functions of the USD/GBP and USD/100Yen exchange rates have a U-shape. Our results reveal that more care has to be taken when determining a diffusion model for the exchange rate. The results also imply that we may have to use a more general diffusion model than those proposed in the literature when developing economic theories for the behavior of the exchange rate and pricing foreign currency options or derivatives.

The Present-Value Model of the Exchange Rate with a Persistently Time-Varying Risk Premium: Evidence from the Dollar-Yen Rate

In this study, I formulate a present value model of the exchange rate with a risk premium and introduce exchange rate risk exposure as a factor of the persistently time-varying risk premium. The present value model incorporates expectations for the distant future, and therefore, indicates that spot exchange rate variations reflect changes in long-run future interest rate differential and exchange rate expectations, in addition to a risk premium for long-run risk exposure. I also conduct empirical analyses using mainly the USD/JPY rate and other exchange rates against the USD. The Japanese current account balance provides a better estimation of the change in USD/JPY rate market risk exposure as USD invoiced trades are prevalent in Japan. Then, I demonstrate the possibility that a persistently time-varying risk premium offsets the effect of the interest rate differential on exchange rate variations, which can be a solution to the uncovered interest rate parity puzzle.