nep-ifn New Economics Papers
on International Finance
Issue of 2008‒11‒11
fourteen papers chosen by
Yi-Nung Yang
Chung Yuan Christian University

  1. Aggregation and the PPP puzzle in a sticky-price model By Carlos Carvalho; Fernanda Nechio
  2. Semi-Nonparametric Estimates of Currency Substitution Between the Canadian Dollar and the U.S. Dollar By Apostolos Serletis; Guohua Feng
  3. McCallum Rules, Exchange Rates, and the Term Structure of Interest Rates By Antonio Diez de los Rios
  4. Foreign exchange market bid-ask spread and market power in an underdeveloped economy By Khemraj, Tarron; Pasha, Sukrishnalall
  5. Mexico's Integration into NAFTA Markets: A View from Sectoral Real Exchange Rates and Transaction Costs By Rodolphe Blavy; Luciana Juvenal
  6. Why Do Countries Peg the Way They Peg?The Determinants of Anchor Currency Choice By Nienke Oomes; Christopher M. Meissner
  7. Taylor Rules and the Euro. By Tanya, Molodtsova; Nikolsko-Rzhevskyy, Alex; Papell, David
  8. The Impact of Yuan/Ringgit on Bilateral Trade Balance of China and Malaysia By Hooy, Chee Wooi; Chan, Tze-Haw
  9. Crossing the Lines: The Conditional Relation between Exchange Rate Exposure and Stock Returns in Emerging and Developed Markets By Bartram, Sohnke M.; Bodnar, Gordon M.
  10. Exchange Rate Regime Choice with Multiple Key Currencies By Thomas Plümper and Eric Neumayer
  11. Carry Trades and Currency Crashes By Markus K. Brunnermeier; Stefan Nagel; Lasse H. Pedersen
  12. The Classification and Perfomance of Alternative Exchange-Rate Systems By George Tavlas; Harris Dellas; Alan Stockman
  13. What Drives Hong Kong Dollar Swap Spreads: Credit or Liquidity? By Cho-Hoi Hui; Lillie Lam
  14. The US as the "Demander of Last Resort" and its Implications on China's Current Account By Joshua Aizenman; Yothin Jinjarak

  1. By: Carlos Carvalho; Fernanda Nechio
    Abstract: We study the purchasing power parity (PPP) puzzle in a multisector, two-country, sticky-price model. Firms' price stickiness differs across sectors, in accordance with recent microeconomic evidence on price setting in various countries. Combined with local currency pricing, these differences lead sectoral real exchange rates to exhibit heterogeneous dynamics. We show that in this economy, deviations of the real exchange rate from PPP are more volatile and persistent when compared with a counterfactual one-sector world economy that features the same average frequency of price changes and is otherwise identical to the multisector world economy. When simulated with a sectoral distribution of price stickiness that matches the microeconomic evidence for the U.S. economy, the model produces a half-life of deviations from PPP of forty-five months. In contrast, the half-life of such deviations in the counterfactual one-sector economy is only slightly above one year. As a by-product, our model provides a decomposition of this difference in persistence that allows a structural interpretation of the approaches found in the empirical literature on aggregation and the real exchange rate. In particular, we reconcile the apparently conflicting findings that gave rise to the "PPP strikes back" debate (Imbs et al. [2005a, b] and Chen and Engel [2005]).
    Keywords: Purchasing power parity ; Prices ; Foreign exchange rates
    Date: 2008
  2. By: Apostolos Serletis; Guohua Feng
    Abstract: In this paper we investigate the issue of whether a floating currency is the right exchangerate regime for Canada or whether Canada should consider a currency union with the UnitedStates. In the context of the framework recently proposed by Swofford (2000, 2005), we usea semi-nonparametric fexible functional form - the Asymptotically Ideal Model (AIM),introduced by Barnett and Jonas (1983) - and pay explicit attention to the theoreticalregularity conditions of neoclassical microeconomic theory, following the suggestions by Bar-nett (2002) and Barnett and Pasupathy (2003). Our results indicate that U.S. dollar depositsare complements to domestic (Canadian) monetary assets, suggesting that Canada shouldcontinue the current exchange rate regime, allowing the exchange rate to float freely with nointervention in the foreign exchange market by the Bank of Canada.
    JEL: C22 F33
    Date: 2008–10–27
  3. By: Antonio Diez de los Rios
    Abstract: McCallum (1994a) proposes a monetary rule where policymakers have some tendency to resist rapid changes in exchange rates to explain the forward premium puzzle. We estimate this monetary policy reaction function within the framework of an affine term structure model to find that, contrary to previous estimates of this rule, the monetary authorities in Canada, Germany and the U.K. respond to nominal exchange rate movements. Our model is also able to replicate the forward premium puzzle.
    Keywords: Exchange rates; Interest rates; Transmission of monetary policy
    JEL: E43 F31 G12 G15
    Date: 2008
  4. By: Khemraj, Tarron; Pasha, Sukrishnalall
    Abstract: This paper explores the influence of trader (or cambio) market power in determining the foreign exchange market bid-ask spread. In particular, it presents a theoretical model that incorporates the notion of oligopolistic power into the foreign exchange market. The econometric analysis substantiates the existence of oligopolistic trader market power in determining the spread. Moreover, the results confirm the prediction of standard market microstructure theory that volatility exerts a positive effect on spread. We also uncovered a positive relationship between liquidity (the quantity of foreign exchange traded) and spread, a result which differs from the existing literature. We interpret this finding to mean that oligopolistic traders set the mark-up exchange rate above where the purely competitive rate would have been so as to generate a surplus of US$ that is then hoarded. The econometric exercise utilizes a unique data set of trading volumes and buying/selling exchange rates for each cambio from January 2000 to December 2007.
    Keywords: bid-ask spread; foreign exchange market; GLS
    JEL: O11 F00 N16 D43
    Date: 2008–10
  5. By: Rodolphe Blavy; Luciana Juvenal
    Abstract: A self-exciting threshold autoregressive model is used to measure transaction costs that may explain relative price differentials and nonlinearities in the behavior of sectoral real exchange rates across Mexico, Canada and the U.S. Interpreting price threshold bands as transactions costs, we find evidence that Mexico still face higher transaction costs than their developed counterparts, even though trade liberalization lowers relative price differentials between countries. The distance between countries and nominal exchange rate volatility are found to be determinants of transaction costs that limit price convergence. Other factors-including weak domestic competition and transportation-are also likely to be important.
    Date: 2008–05–15
  6. By: Nienke Oomes; Christopher M. Meissner
    Abstract: What determines the currency to which countries peg or "anchor" their exchange rate? Data for over 100 countries between 1980 and 1998 reveal that trade network externalities are a key determinant. This implies that anchor currency choice may well be suboptimal in that certain currencies, e.g., the U.S. dollar, could be oversubscribed. It also implies that changes in anchor choices by a small number of countries can have large and rapid effects on the international monetary system. Other factors found to be related to anchor choice include the symmetry of output shocks and the currency denomination of liabilities.
    Keywords: Currency pegs , Exchange rates , International monetary system ,
    Date: 2008–05–27
  7. By: Tanya, Molodtsova; Nikolsko-Rzhevskyy, Alex; Papell, David
    Abstract: This paper uses real-time data to analyze whether the variables that normally enter central banks’ interest-rate-setting rules, which we call Taylor rule fundamentals, can provide evidence of out-of-sample predictability for the United States Dollar/Euro exchange rate from the inception of the Euro in 1999 to the end of 2007. The major result of the paper is that the null hypothesis of no predictability can be rejected against an alternative hypothesis of predictability with Taylor rule fundamentals for a wide variety of specifications that include inflation and a measure of real economic activity in the forecasting regression. We also present less formal evidence that, with real-time data, the Taylor rule provides a better description of ECB than of Fed policy during this period. While the evidence of predictability is only found for specifications that do not include the real exchange rate in the forecasting regression, the results are robust to whether or not the coefficients on inflation and the real economic activity measure are constrained to be the same for the U.S. and the Euro Area and to whether or not there is interest rate smoothing. The evidence of predictability is stronger for real-time than for revised data, about the same with inflation forecasts as with inflation rates, and weakens if output gap growth is included in the forecasting regression. Bad news about inflation and good news about real economic activity both lead to out-of-sample predictability through forecasted exchange rate appreciation.
    Keywords: Taylor rule; euro; exchange rate; forecasting; ECB; euro area.
    JEL: F37 E58 E52 F31
    Date: 2008–09–29
  8. By: Hooy, Chee Wooi; Chan, Tze-Haw
    Abstract: The exposure to exchange rates remains an unresolved issue in international trade literature. The issue is particularly relevant to China and Malaysia, whom relaxed their USD pegging the same day in the mid of 2005. Our paper investigates the exchange rate exposure of China-Malaysian bilateral trade balance over the last 20 years using a standard trade balance equation which is a function of local income, foreign income, and the bilateral real exchange rates of yuan/ringgit. Our modeling is somewhat different with the literature where we take into account the structural breaks of the 1997 Asian currency crisis as well as the fixed-exchange rate regime adopted by the Malaysia. With high frequency monthly sample (Jan1990-Jan2008), we documented GARCH effect in the trade model. Taking that into consideration, our result shows that real exchange rates do play a role in the bilateral trade of China-Malaysia. The long run exchange rate elasticity is consistent with the Marshall-Lerner condition. However, the short run J-curve phenomenon is somewhat inconclusive.
    Keywords: Exports; Imports; exchange rates exposure; J-curve; structural breaks; GARCH
    JEL: C32 F10 F41 F31
    Date: 2008–10–01
  9. By: Bartram, Sohnke M.; Bodnar, Gordon M.
    Abstract: This paper examines the importance of exchange rate risk in the return generating process for a large sample of non-financial firms from 37 countries. We argue that the effect of exchange rate exposure on stock returns should be conditional and show evidence of a significant return premium to firm-level currency exposures when conditioning on the exchange rate change. The return premium is directly related to the size and sign of the subsequent exchange rate change, suggesting fluctuations in exchange rates themselves as a source of time-variation in currency risk premia. For the entire sample the return premium ranges from 1.2 - 3.3% per unit of currency exposure. The premium is larger for firms in emerging markets, while in developed markets it is statistically significant only for local currency depreciations. Overall, the results indicate that exchange rate exposure plays an important role in generating cross-sectional return variation. Moreover, we show that the impact of exchange rate risk on stock returns is predominantly a cash flow effect as opposed to a discount rate effect.
    Keywords: Exchange rate exposure; exchange rate risk; return premia; international finance
    JEL: G1 F3 F2
    Date: 2006–06–22
  10. By: Thomas Plümper and Eric Neumayer
    Abstract: Recent scholarship on exchange rate regime choice seeks to explain why some countries fix their exchange rate to an anchor currency, but it neglects the question to which currency countries peg. This article posits that an understanding of the choice of anchor currency also improves political economists’ understanding of the decision for an exchange rate peg itself. Drawing on the ‘fear of floating literature’, we argue that the choice of anchor currency is mainly determined by the degree of dependence of the potentially pegging country on imports from the country or currency union issuing the key currency as well as the degree of dependence on imports from the currency area, that is, from other countries which have already pegged to that key currency. This is because an exchange rate depreciation against the main trading partners’ currency increases domestic inflationary pressures due to exchange-rate pass-through. In addition, our theory claims that central bank independence and de facto fixed exchange rates are complements (rather than substitutes) since independent central banks care more than governments about imported inflation. Analyzing a pooled cross-section of 106 countries over the period 1974 to 2005, we find ample evidence in support of our theoretical predictions.
    Date: 2008–11–04
  11. By: Markus K. Brunnermeier; Stefan Nagel; Lasse H. Pedersen
    Abstract: This paper documents that carry traders are subject to crash risk: i.e. exchange rate movements between high-interest-rate and low-interest-rate currencies are negatively skewed. We argue that this negative skewness is due to sudden unwinding of carry trades, which tend to occur in periods in which risk appetite and funding liquidity decrease. Funding liquidity measures predict exchange rate movements, and controlling for liquidity helps explain the uncovered interest-rate puzzle. Carry-trade losses reduce future crash risk, but increase the price of crash risk. We also document excess co-movement among currencies with similar interest rate. Our findings are consistent with a model in which carry traders are subject to funding liquidity constraints.
    JEL: E44 F3 F31 G12
    Date: 2008–11
  12. By: George Tavlas (Bank of Greece); Harris Dellas (University of Bern); Alan Stockman (University of Rochester)
    Abstract: Owing to dissatisfaction with the IMF’s de jure classification of exchange-rate regimes, a substantial literature has emerged presenting de facto classifications of exchange-rate systems and using the latter classifications to compare performances of alternative regimes in terms of key macroeconomic variables. This paper critically reviews the literature on de facto regimes. In particular the paper (1) describes the main methodologies that have been used to construct de facto codings, (2) surveys the empirical literature generated by de facto regime codings, and (3) lays-out the problems inherent in constructing de facto classifications. The empirical literature is found to yield few robust findings. We argue that the as-yet unfulfilled objective of this literature, and the major research agenda for the future in this area, lies in the need of a more thorough investigation of the degree of monetary-policy independence without relying exclusively on movements in exchange rates, an agenda the attainment of which is made especially challenging because of the lack of comprehensive and reliable data on reserves and interest rates.
    Keywords: Exchange-rate regimes; Economic growth; Inflation; Bipolar hypothesis
    JEL: F3
    Date: 2008–09
  13. By: Cho-Hoi Hui (Research Department, Hong Kong Monetary Authority); Lillie Lam (Research Department, Hong Kong Monetary Authority)
    Abstract: This paper investigates the determinants of variations in the yield spreads (swap spreads) between Hong Kong dollar interest rate swaps and Exchange Fund paper for a period from July 2002 to April 2008. A vector error-correction model is used to analyse the impact of various shocks on swap spreads. The issue is whether "liquidity" or "credit" (or both) is the main determinant of swap spread dynamics. The results show that the dynamics are influenced significantly by "credit" between July 2002 and September 2007. However, "liquidity" between the Exchange Fund long-term notes and short-term bills is the major determinant of swap spreads between September 2007 and April 2008. The substantial demand of the Exchange Fund short-term bills, that reflected the strong preference of market participants for holding short-term instruments for liquidity purposes probably due to the sub-prime crisis in the US, is the driving force of the rise in swap spreads in the last quarter of 2007.
    Keywords: Hong Kong dollar interest rates, swap spreads, vector error-correction model, sub-prime crisis
    JEL: G15 E43
    Date: 2008–07
  14. By: Joshua Aizenman; Yothin Jinjarak
    Abstract: This paper evaluates the degree to which current account patterns are explained by the variables suggested by the literature, and reflects on possible future patterns. We start with panel regressions explaining the current account of 69 countries during 1981-2006. We identify an asymmetric effect of the US as the "demander of last resort:" a 1% increase in the lagged US current account deficit is associated with 0.5% increase of current account surpluses of countries running surpluses, but with insignificant changes of current account deficits of countries running deficits. Overall, the panel regressions account for not more than 2/3 of the variation. We apply the regression results to assess China's current account over the next six years, projecting a large drop in its account/GDP surpluses.
    JEL: F15 F32
    Date: 2008–10

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