nep-ifn New Economics Papers
on International Finance
Issue of 2005‒11‒12
ten papers chosen by
Yi-Nung Yang
Chung Yuan Christian University

  1. Explaining exchange rate dynamics - the uncovered equity return parity condition By Elizaveta Krylova; Lorenzo Cappiello; Roberto A. De Santis
  2. Market power, innovative activity and exchange rate pass-through in the euro area By Sophocles N. Brissimis; Theodora S. Kosma
  3. Monetary policy and the illusionary exchange rate puzzle By Hilde C. Bjørnland
  4. How successful are exchange rate communication and interventions? Evidence from time-series and event-study approaches By Marcel Fratzscher
  5. Cape Verde's exchange rate policy and its alternatives By Romain Weber
  6. Foreign Exchange Market Microstructure By Martin D. D. Evans (Georgetown University)
  7. Cross-dynamics of volatility term structures implied by foreign exchange options By Elizaveta Krylova; Jussi Nikkinen; Sami Vähämaa
  8. Arbitrage in the foreign exchange market: Turning on the microscope By Q. Farooq Akram,; Dagfinn Rime; Lucio Sarno
  9. How Homogenous are Currency Crises? A Panel Study using Multiple-Response Models By Tassos Anastasatos; Ian R. Davidson
  10. Macroeconomic and Distributional Effects of Devaluation in a Dollarized Economy: A CGE Analysis for Bolivia By Rainer Schweickert; Rainer Thiele; Manfred Wiebelt

  1. By: Elizaveta Krylova (European Central Bank, Market Operations, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany); Lorenzo Cappiello (DG-Research, European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany); Roberto A. De Santis (DG Economics, European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany)
    Abstract: By employing Lucas’ (1982) model, this study proposes an arbitrage relationship – the Uncovered Equity Return Parity (URP) condition – to explain the dynamics of exchange rates. When expected equity returns in a country/region are lower than expected equity returns in another country/region, the currency associated with the market offering lower returns is expected to appreciate. First, we test the URP assuming that investors are risk neutral and next we relax this hypothesis. The resulting risk premia are proxied by economic variables, which are related to the business cycle. We employ differentials in corporate earnings’ growth rates, short-term interest rate changes, annual inflation rates, and net equity flows. The URP explains a large fraction of the variability of some European currencies vis-à-vis the US dollar. When confronted with the naïve random walk model, the URP for the EUR/USD performs better in terms of forecasts for a set of alternative statistics.
    Keywords: Foreign exchange markets; asset pricing; random walk; UIP; GMM.
    JEL: F31 G15 C22 C53
    Date: 2005–09
  2. By: Sophocles N. Brissimis (Bank of Greece and University of Piraeus. Address: 21 E.Venizelos Ave., 10250 Athens, Greece.); Theodora S. Kosma (Corresponding author: Athens University of Economics and Business (AUEB), 76 Patission Street, 10434 Athens, Greece.)
    Abstract: This paper examines exchange rate pass-through in the euro area by accounting for the impact of exchange rate changes on exporting firms’ market power, cost structure and competitiveness. An international oligopoly model where exporting firms simultaneously decide on their pricing and innovation strategies is used as the basis for the econometric analysis. The estimations are carried out on data for manufacturing imports of three large euro area countries (Germany, France, Netherlands) from three major non-euro area import suppliers (US, Japan, UK). The results show that exporting firms’ price and innovation decisions in each source country are jointly determined and that total pass-through to euro area import prices is low. There are also indications that other factors, such as interactions with domestic producers, may be important for the determination of pass-through. Finally, euro area import prices are found to be sticky in local currency in the short run.
    Keywords: Exchange rate pass-through; market power; innovative activity; multivariate cointegration; euro exchange rate.
    JEL: C32 F39 L13 O31
    Date: 2005–10
  3. By: Hilde C. Bjørnland (Department of Economics, University of Oslo and Norges Bank (Central Bank of Norway))
    Abstract: Dornbusch’s exchange rate overshooting hypothesis is a central building block in international macroeconomics. Yet, empirical studies of monetary policy have typically found exchange rate effects that are inconsistent with overshooting. This puzzling result has developed into a “styled facts” to be reckoned with in policy modelling. However, many of these studies, in particular those using VARs, have disregarded the strong contemporaneous interaction between monetary policy and exchange rate movements by placing zero restriction on them. By instead imposing a long-run neutrality restriction on the real exchange, thereby allowing the interest rate and the exchange rate to react simultaneously to any news, I find that the puzzles disappear. In particular, a contractionary monetary policy shock has a strong effect on the exchange rate that appreciates on impact. The maximum effect occurs immediately, and the exchange rate thereafter gradually depreciates to baseline, consistent with the Dornbusch overshooting hypothesis and with few exceptions consistent with UIP.
    Keywords: Dornbusch overshooting, VAR, monetary policy, exchange rate puzzle, identification
    JEL: C32 E52 F31 F41
    Date: 2005–11–09
  4. By: Marcel Fratzscher (European Central Bank, DG-Research, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany)
    Abstract: The paper analyses whether communication and actual interventions in FX markets are successful in moving exchange rates over the medium- to long-run. It compares empirical evidence based on time-series analysis with that obtained from an eventstudy approach. Both the time-series approach based on option contracts and the event-study methodology yield compelling evidence that communication and actual interventions tend to be successful in moving exchange rates in the desired direction contemporaneously as well as over the medium- to long-term. This finding is consistent with recent work on microstructure models that emphasises the importance of dynamic effects of news and fundamentals on exchange rates.
    Keywords: Communication; exchange rate; intervention; policy; time-series analysis; event-study methodology; United States; euro area; Japan.
    JEL: E61 E58 F31
    Date: 2005–09
  5. By: Romain Weber
    Abstract: This paper analyses Cape Verde's exchange rate policy and investigates whether viable alternatives exist. Cape Verde currently operates a fixed exchange rate regime which, since 1999, links the national currency to the euro. The fixed exchange rate has many benefits, but authorities have to leave interest rates high in order to attract foreign capital, which has inhibited private investment and economic growth; the appreciation of the euro in 2002 and 2003 put the fixed exchange rate under additional strain. This issue is addressed by contemplating whether interest rates can be reduced in the context of the current exchange rate regime, and what costs and benefits are associated with a regime change that enables a reduction in interest rates. The analysis strongly suggests that it is not so much the exchange rate regime that is to blame for high interest rates, but rather a structural problem in the banking sector. Consequently, the policy conclusion reached in this paper is that although changing the current exchange rate policy might reduce interest rates, structural reforms would be more appropriate to tackle the problem at hand.
    Date: 2005–10
  6. By: Martin D. D. Evans (Georgetown University) (Department of Economics, Georgetown University)
    Abstract: This paper provides an overview of the recent literature on Foreign Exchange Market Microstructure. Its aim is not to survey the literature, but rather to provide an introductory tour to the main theoretical ideas and empirical results. The central theoretical idea is that trading is an integral part of the process through which information relevant to the pricing of foreign currency becomes embedded in spot rates. Micro-based models study this information aggregation process and produce a rich set of empirical predictions that find strong support in the data. In particular, micro-based models can account for a large proportion of the daily variation in spot rates. They also supply a rationale for the apparent disconnect between spot rates and fundamentals. In terms of forecasting, micro-based models provide out-of-sample forecasting power for spot rates that is an order of magnitude above that usually found in exchange-rate models. Classification-JEL Codes: F3, F4, G1
    Keywords: Exchange Rates, Microstructure, Information Aggregation, FX Trading.
  7. By: Elizaveta Krylova (European Central Bank, Market Operations, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany); Jussi Nikkinen (University of Vaasa, Department of Accounting and Finance, P.O. Box 700, 65101 Vaasa, Finland); Sami Vähämaa (University of Vaasa, Department of Accounting and Finance, P.O. Box 700, 65101 Vaasa, Finland)
    Abstract: This paper examines the cross-dynamics of volatility term structures implied by foreign exchange options. The data used in the empirical analysis consist of daily observations of implied volatilities for OTC options on the euro, Japanese yen, British pound, Swiss franc, and Canadian dollar, quoted against the U.S. dollar. The empirical findings demonstrate that two common factors can explain a vast proportion of the variation in volatility term structures across currencies. Furthermore, the results indicate that the euro is the dominant currency, as the implied volatility term structure of the euro is found to affect all the other volatility term structures, while the term structure of the euro appears to be virtually unaffected by the other currencies. Finally, our results reveal a rather deviant relation between the volatility term structures of the euro and Swiss franc by providing evidence of significant nonlinearities in the relationship between these two currencies.
    Keywords: Implied volatility; volatility term structure; foreign exchange options.
    JEL: F31 G13 G15
    Date: 2005–09
  8. By: Q. Farooq Akram, (Norges Bank (Central Bank of Norway)); Dagfinn Rime (Norges Bank (Central Bank of Norway)); Lucio Sarno (University of Warwick and CEPR)
    Abstract: This paper investigates the presence and characteristics of arbitrage opportunities in the foreign exchange market using a unique data set for three major capital and foreign exchange markets that covers a period of more than seven months at tick frequency, obtained from Reuters on special order. We provide evidence on the fre- quency, size and duration of round-trip and one-way arbitrage opportunities in real time. The analysis unveils the existence of numerous short-lived arbitrage oppor- tunities, whose size is economically significant across exchange rates and comparable across different maturities of the instruments involved in arbitrage. The duration of arbitrage opportunities is, on average, high enough to allow agents to exploit devia- tions from the law of one price, but low enough to explain why such opportunities have gone undetected in much previous research using data at lower frequency.
    Keywords: exchange rates; arbitrage; foreign exchange microstructure
    JEL: F31 F41 G14 G15
    Date: 2005–11–09
  9. By: Tassos Anastasatos (Dept of Economics Univ. of Loughborough); Ian R. Davidson (Business School Univ. of Loughborough)
    Abstract: This paper presents formal evidence that currency episodes display heterogeneity in terms of their evolution, their impact on the inflicted economy and their links with financial, political and macroeconomic fundamentals. Limited-dependent variable models for ordered and unordered outcomes along with their heteroskedastic and random effects extensions are applied on a large panel of data comprising 40 years of monthly observations on 23 developed countries. Heterogeneity, complemented by indications of self-fulfilling expectations and noise, suggest that time and region specific predictive approaches and policy responses are more useful than trying to base analysis and policy decisions on more general patterns. Results are established with formal specification tests.
    Keywords: Currency crises; speculative pressure; exchange rate; devaluation; Limited-dependent variable models.
    JEL: F31 C23 C25 E44 G15
    Date: 2004–12
  10. By: Rainer Schweickert (IFW, Kiel); Rainer Thiele (IFW, Kiel); Manfred Wiebelt (IFW, Kiel)
    Abstract: In this paper, a real-financial CGE model is employed for Bolivia to simulate the macroeconomic and distributional effects of exchange rate policy in a highly dollarized economy. Overall, dollarization appears to matter more through real than through financial-sector effects. The main macroeconomic result of the simulations is that the potential of nominal devaluation to smooth the adjustment path after a negative shock primarily depends on the absence of wage indexation. Only if nominal wages are constant in the short run, devaluation reduces unemployment and cushions the reduction of real GDP induced by the shock. Financial de-dollarization tends to be contractionary in Bolivia but different degrees of financial dollarization hardly change the real sector effects. As concerns distributional effects, nominal devaluation in no circumstance reduces the poverty effect of the external shock. Even the significant short-run macroeconomic expansion that occurs without wage indexation does not translate into significant poverty alleviation, given the offsetting effects of devaluation on real factor incomes, real interest incomes, and real transfers received by households.
    Keywords: Dollarization, Poverty, Computable General Equilibrium Model, Bolivia
    JEL: D3 C68
    Date: 2005–10–21

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