nep-ifn New Economics Papers
on International Finance
Issue of 2006‒05‒20
eight papers chosen by
Yi-Nung Yang
Chung Yuan Christian University

  1. Expectations and Exchange Rate Policy By Michael B. Devereux; Charles Engel
  2. Expenditure Switching vs. Real Exchange Rate Stabilization: Competing Objectives for Exchange Rate Policy By Michael B. Devereux; Charles Engel
  3. The Case for an International Reserve Diversification Standard By Edwin M. Truman; Anna Wong
  4. Towards Decoding Currency Volatilities By D. Johannes Juttner; Wayne Leung
  5. Currency hedging of global portfolios - a closer examination of some of the ingredients By D. Johannes Juttner; Wayne Leung
  6. The Economic Consequences of Dollar Appreciation for U.S. Manufacturing Investment: A Time-Series Analysis By Robert A. Blecker
  7. Portfolio Choice in a Monetary Open-Economy DSGE Model By Charles Engel; Akito Matsumoto
  8. Backtesting VaR Accuracy: A New Simple Test By Christophe Hurlin; Sessi Tokpavi

  1. By: Michael B. Devereux; Charles Engel
    Abstract: Both empirical evidence and theoretical discussion have long emphasized the impact of “news” on exchange rates. In most exchange rate models, the exchange rate acts as an asset price, and as such responds to news about future returns on assets. But the exchange rate also plays a role in determining the relative price of non-durable goods when nominal goods prices are sticky. In this paper we argue that these two roles may conflict with one another. If news about future asset returns causes movements in current exchange rates, then when nominal prices are slow to adjust, this may cause changes in current relative goods prices that have no efficiency rationale. In this sense, anticipations of future shocks to fundamentals can cause current exchange rate misalignments. Friedman’s (1953) case for unfettered flexible exchange rates is overturned when exchange rates are asset prices. We outline a series of models in which an optimal policy eliminates the effects of news on exchange rates.
    JEL: F3 F4 E5
    Date: 2006–05
  2. By: Michael B. Devereux; Charles Engel
    Abstract: This paper develops a view of exchange rate policy as a trade-off between the desire to smooth fluctuations in real exchange rates so as to reduce distortions in consumption allocations, and the need to allow flexibility in the nominal exchange rate so as to facilitate terms of trade adjustment. We show that optimal nominal exchange rate volatility will reflect these competing objectives. The key determinants of how much the exchange rate should respond to shocks will depend on the extent and source of price stickiness, the elasticity of substitution between home and foreign goods, and the amount of home bias in production. Quantitatively, we find the optimal exchange rate volatility should be significantly less than would be inferred based solely on terms of trade considerations. Moreover, we find that the relationship between price stickiness and optimal exchange rate volatility may be non-monotonic.
    JEL: F3 F4 E5
    Date: 2006–05
  3. By: Edwin M. Truman (Institute for International Economics); Anna Wong (Institute for International Economics)
    Abstract: Rumors about the actual or potential currency diversification of countries’ foreign exchange holdings out of dollars are not a new phenomenon. This working paper argues that such concerns about reserve diversification are exaggerated. We present evidence that the extent of actual diversification has been modest to date. Nevertheless, the potential for reserve diversification adds volatility to foreign exchange markets and can catalyze abrupt exchange rate movements. We argue that policymakers acting in their own national interests can do something constructive to reduce the volatility introduced into foreign exchange and financial markets by rumors of large-scale international foreign exchange reserve diversification. We propose the voluntary adoption by major foreign exchange reserve holders in particular of an International Reserve Diversification Standard consisting of two elements: (1) routine disclosure of the currency composition of official foreign exchange holdings and (2) a commitment by each adherent to adjust gradually the actual currency composition of its reserves to any new benchmark for those holdings.
    Keywords: Foreign Exchange Reserves, Central Banks, International Investment and Long-Term Capital Movements, International Monetary Arrangements and Institutions
    JEL: F31 E58 F21 F33
    Date: 2006–05
  4. By: D. Johannes Juttner (Department of Economics, Macquarie University); Wayne Leung (Department of Economics, Macquarie University)
    Abstract: This study contributes, on the basis of economic theory, to an explanation of exchange rate volatilities for a large number of currencies. We relate daily changes in GARCH(1,1) volatilities of exchange rates to the volatility changes of several of their presumed fundamental economic determinants. The use of highfrequency data limits the choice of the explanatory economic variables that can be included. The first differences of GARCH(1,1) volatilities of share and bond price indices proxy for wealth uncertainty and the latter, in addition, for interest rate variability. Likewise, first differences of the gold price volatility, as an additional determinant, are related to exchange rate volatilities of two commodity currencies in the sample. The estimates produce coefficients with the expected signs and statistical significance.
    Keywords: Exchange rate volatilities, volatility relationships, GARCH modelling
    JEL: F31 C22
    Date: 2004–08
  5. By: D. Johannes Juttner (Department of Economics, Macquarie University); Wayne Leung (Department of Economics, Macquarie University)
    Abstract: The paper analyzes some of the ingredients of currency hedging and portfolio construction against the framework of mean-variance efficient portfolios. The currency hedging analysis is based on a range of exchange rates, consisting of the domestic dollar vis-à-vis the US dollar, the euro, the yen, the pound and Hong Kong dollar mainly from an Australian perspective. Our analysis focuses on the following input factors into the hedging process of foreign assets/liabilities. We explore the implications of the secular downward trend of the real trade-weighted exchange rate index of the domestic dollar for hedging effectiveness. The hedging costs resulting from unexpected cash flows and portfolio adjustments are in part estimated through a simulated forward contract hedging technique. The relevant inputs into the variance-covariance matrix of the optimal portfolio selection process are estimated on the basis of historical data. Comparing the forecast errors of share index and currency volatilities, using historical, implied and GARCH methods, provides mixed results. The paper also investigates a select number of forecasting methods that may be applied to other hedging inputs.
    Date: 2004–10
  6. By: Robert A. Blecker (Department of Economics, American University)
    Abstract: This paper analyzes the effects of the real value of the dollar on investment in US domestic manufacturing, using aggregate time-series data for 1973-2004. The econometric estimates reveal robust evidence for a negative effect of the dollar that is much larger than has been found in any previous study (and which is not sensitive to various alternative specifications). The results also suggest that the exchange rate affects investment mainly, although not exclusively, through the channel of financial or liquidity constraints, rather than by affecting the desired stock of capital. Counterfactual simulations show that US manufacturing investment would have been 61% higher and the capital stock would have been 17% higher in 2004 if the dollar had not appreciated after 1995.
    Keywords: investment, manufacturing, exchange rate, US dollar, profits, US economy
    JEL: E22 F31 L60 E25
    Date: 2006–05
  7. By: Charles Engel; Akito Matsumoto
    Abstract: This paper develops a two-country monetary DSGE model in which households choose a portfolio of home and foreign equities, and a forward position in foreign exchange. Some goods prices are set without full information of the state. We show that temporarily sticky nominal goods prices can have large effects on equity portfolios. Home and foreign portfolios are not identical in equilibrium. In response to technology shocks, sticky prices generate a negative correlation between labor income and the profits of domestic firms, biasing portfolios in favor of home equities. In contrast, under flexible prices, labor income and the profits of the domestic firms are positively correlated. Even a small amount of nominal price stickiness can generate these portfolio differences, depending on the diversification role played by the terms of trade. Returns on human capital and equities may be positively correlated under sticky prices when the source of shocks is monetary, but this risk is hedged through nominal assets rather than through equities.
    JEL: F31 F41 G11
    Date: 2006–05
  8. By: Christophe Hurlin (LEO - Laboratoire d'économie d'Orleans - [CNRS : UMR6221] - [Université d'Orléans]); Sessi Tokpavi (LEO - Laboratoire d'économie d'Orleans - [CNRS : UMR6221] - [Université d'Orléans])
    Abstract: This paper proposes a new test of Value at Risk (VaR) validation. Our test exploits the idea that the sequence of VaR violations (Hit function) - taking value 1-α, if there is a violation, and -α otherwise - for a nominal coverage rate α verifies the properties of a martingale difference if the model used to quantify risk is adequate (Berkowitz et al., 2005). More precisely, we use the Multivariate Portmanteau statistic of Li and McLeod (1981) - extension to the multivariate framework of the test of Box and Pierce (1970) - to jointly test the absence of autocorrelation in the vector of Hit sequences for various coverage rates considered as relevant for the management of extreme risks. We show that this shift to a multivariate dimension appreciably improves the power properties of the VaR validation test for reasonable sample sizes.
    Keywords: Value-at-Risk; Risk Management; Model Selection
    Date: 2006–05–11

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