nep-ifn New Economics Papers
on International Finance
Issue of 2009‒07‒11
five papers chosen by
Yi-Nung Yang
Chung Yuan Christian University

  1. Model misspecification, learning and the exchange rate disconnect puzzle By Vivien Lewis; Agnieszka Markiewicz
  2. The Exchange Rate Effect of Multi-Currency Risk Arbitrage By Hau, Harald
  3. China's Current Account and Exchange Rate By Yin-Wong Cheung; Menzie D. Chinn; Eiji Fujii
  4. A Multiple-Horizon Search for the Role of Trade and Financial Factors in Bilateral Real Exchange Rate Volatility By Yin-Wong Cheung; Kon S. Lai
  5. Financial Crises and International Trade: The Long Way to Recovery By Nicolas Berman

  1. By: Vivien Lewis (National Bank of Belgium, Research Department; Ghent University, Department of Financial Economics); Agnieszka Markiewicz (Erasmus University Rotterdam, Department of Economics)
    Abstract: Rational expectations models fail to explain the disconnect between the exchange rate and macroeconomic fundamentals. In line with survey evidence on the behaviour of foreign exchange traders, we introduce model misspecification and learning into a standard monetary model. Agents use simple forecasting rules based on a restricted information set. They learn about the parameters and performance of different models and can switch between forecasting rules. We compute the implied post-Bretton Woods US dollar-pound sterling exchange rate and show that the excess volatility of the exchange rate return can be reproduced with low values of the learning gain. Both assumptions, misspecification and learning, are necessary to generate this result. However, the implied correlations with the fundamentals are higher than in the data. Including more lags in the model tends to tip the balance of our findings slightly towards rational expectations and away from the learning hypothesis
    Keywords: exchange rate, disconnect, misspecification, learning
    JEL: F31 E37 E44
    Date: 2009–07
  2. By: Hau, Harald
    Abstract: This paper documents how currency speculators trade when international capital flows generate predictable exchange rate movements. The redefinition of the MSCI world equity index in December 2000 provides an ideal natural experiment identifying exogenous capital flows of index tracking equity funds. Currency speculators are shown to front-run international capital flows. Furthermore, they actively manage the portfolio risk of their speculative positions through hedging positions in correlated currencies. The exchange rate effect of separate risk hedging is economically significant and amounts to a return difference of 3.6 percent over a 5 day event window between currencies with high and low risk hedging value. The results of the classical event study analysis are confirmed by a new and more powerful spectral inference isolating the high frequency cospectrum of currency pairs. The evidence supports the idea that international currency arbitrage is limited by the speculators' risk aversion.
    Keywords: Cospectrum; Limited Arbitrage; Multi-Currency Risk Hedging; Spectral Inference; Speculative Trading
    JEL: F31 G11 G14 G15
    Date: 2009–06
  3. By: Yin-Wong Cheung (University of California, Santa Cruz); Menzie D. Chinn (University of Wisconsin, Madison, NBER); Eiji Fujii (University of Tsukuba)
    Abstract: We examine whether the Chinese exchange rate is misaligned and how Chinese trade flows respond to the exchange rate and to economic activity. We find, first, that the Chinese currency, the renminbi (RMB), is substantially below the value predicted by estimates based upon a cross-country sample, when using the 2006 vintage of the World Development Indicators. The economic magnitude of the misalignment is substantial ¡V on the order of 50 percent in log terms. However, the misalignment is typically not statistically significant, in the sense of being more than two standard errors away from the conditional mean. However, this finding disappears completely when using the most recent 2008 vintage of data; then the estimated undervaluation is on the order of 10 percent. Second, we find that Chinese multilateral trade flows respond to relative prices ¡V as represented by a trade weighted exchange rate ¡V but the relationship is not always precisely estimated. In addition, the direction of the effects is sometimes different from what is expected a priori. For instance, Chinese ordinary imports actually rise in response to a RMB depreciation; however, Chinese exports appear to respond to RMB depreciation in the expected manner, as long as a supply variable is included. In that sense, Chinese trade is not exceptional. Furthermore, Chinese trade with the United States appears to behave in a standard manner ¡V especially after the expansion in the Chinese manufacturing capital stock is accounted for. Thus, the China-US trade balance should respond to real exchange rate and relative income movements in the anticipated manner. However, in neither the case of multilateral nor bilateral trade flows should one expect quantitatively large effects arising from exchange rate changes. And, of course, these results are not informative with regard to the question of how a change in the RMB/USD exchange rate would affect the overall US trade deficit. Finally, we stress the fact that considerable uncertainty surrounds both our estimates of RMB misalignment and the responsiveness of trade flows to movements in exchange rates and output levels. In particular, the results for trade elasticities are sensitive to econometric specification, accounting for supply effects, and for the inclusion of time trends.
    Date: 2009–04
  4. By: Yin-Wong Cheung (University of California, Santa Cruz); Kon S. Lai (California State University, Los Angeles)
    Abstract: This study investigates the sources of bilateral real exchange rate (RER) volatility in industrial countries. Going beyond traditional macroeconomic determinants, we identify the role of both tradeand finance-related factors in explaining RER volatility at different time horizons. The results suggest that RER volatility tends to increase with financial openness and with transport costs but decrease with trade openness and with financial depth. Moreover, the time horizon matters. Financial factors (financial openness and financial depth) are found to influence RER volatility at primarily short horizons, while trade-related factors (trade openness and transport costs) contribute significantly also to RER volatility at much longer horizons. The relative importance of traditional macroeconomic fundamentals and these trade- and finance-related factors can vary considerably across horizons.
    Keywords: Exchange Rate Volatility, Time Horizons, Trade Openness, Financial Openness, Financial Depth
    JEL: F15 F31 F41
    Date: 2009–06
  5. By: Nicolas Berman
    Abstract: Standard theoretical models would predict that a currency depreciation generates an increase in net exports. However, recent emerging market crises, accompanied by sharp exchange rate devaluations, have often been followed by a fall in or a stagnation of exports. This paper provides a simple theoretical framework which shows that a currency crisis affects trade through (i) a competitiveness effect, i.e. a variation in relative prices, that positively influences the intensive margin of trade (the amount of exports by firms); (ii) a balance-sheet effect, i.e. a modification of the fixed cost of exports, which negatively affects the extensive margin of trade (the number of exporters). We derive from our model a gravity-like equation of bilateral sectoral trade which we estimate using data on 27 industries and 32 countries over the period 1976-2002. First, we find that these events have a long-lasting negative impact on exports - which remain below their natural level for five years. We present evidence suggesting that this persistent effect is due to the combination of firms’ foreign currency borrowing and fixed costs of exports, which leads to important balance-sheet problems in the aftermath of the crisis. Second, the net effect of crises on exports largely depends on country specialization: the positive competitiveness effect is magnified by a specialization in high elasticity of substitution’s industries, while negative balance-sheets effects are exacerbated in industries more dependent upon external finance, in which assets are more tangible, or in high fixed costs sectors.
    Keywords: Currency Crises, International Trade, Gravity Equation, Balance-sheet effects, Fixed Costs
    JEL: F10 F12 F17 F34
    Date: 2009

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