nep-ifn New Economics Papers
on International Finance
Issue of 2021‒05‒24
seven papers chosen by
Vimal Balasubramaniam
University of Oxford

  1. The Global Factor Structure of Exchange Rates By Korsaye, Sofonias Alemu; Trojani, Fabio; Vedolin, Andrea
  2. Dominant Currencies: How firms choose currency invoicing and why it matters By Amiti, Mary; Itskhoki, Oleg; Konings, Jozef
  3. Global Financial Cycle and Liquidity Management By Jeanne, Olivier; Sandri, Damiano
  4. Investment funds, monetary policy, and the global financial cycle By Kaufmann, Christoph
  5. The Economics of Currency Risk By Hassan, Tarek Alexander; Zhang, Tony
  6. Exchange Rate Prediction with Machine Learning and a Smart Carry Trade Portfolio By Filippou, Ilias; Rapach, David; Taylor, Mark P; Zhou, Guofu
  7. Prospect Theory and Currency Returns: Empirical Evidence By Kozhan, Roman; Taylor, Mark P; Xu, Qi

  1. By: Korsaye, Sofonias Alemu; Trojani, Fabio; Vedolin, Andrea
    Abstract: We provide a model-free framework to study the global factor structure of exchange rates. To this end, we propose a new methodology to estimate international stochastic discount factors (SDFs) that jointly price cross-sections of international assets, such as stocks, bonds, and currencies, in the presence of frictions. We theoretically establish a two-factor representation for the cross-section of international SDFs, consisting of one global and one local factor, which is independent of the currency denomination. We show that our two-factor specification prices a large cross-section of international asset returns, not just in- but also out-of-sample with R2s of up to 80%.
    Keywords: Capital Flows; factor models; Financial Frictions; incomplete markets; International Asset Pricing; Lasso; Market Segmentation; regularization; Stochastic discount factor
    JEL: F31 G15
    Date: 2020–10
  2. By: Amiti, Mary; Itskhoki, Oleg; Konings, Jozef
    Abstract: The currency of invoicing in international trade is central for the international transmission of shocks and macroeconomic policies. Using a new dataset on currency invoicing for Belgian firms, we analyze how firms make their currency choice, for both exports and imports, and the implications of this choice for exchange rate pass-through into prices and quantities. We derive our estimating equations from a theoretical framework that features variable markups, international input sourcing, and staggered price setting with endogenous currency choice, and also allowing for the dominant currency choice. Our structural specification provides a new test of the allocative consequences of nominal rigidities, by estimating the treatment effect of foreign-currency price stickiness on the dynamic response of prices and quantities to exchange rate changes, controlling for the endogeneity of the firm's currency choice. We show that flexible-price determinants of exchange rate pass-through are also the key firm characteristics that determine currency choice. In particular, small non-importing firms tend to price their exports in euros (producer currency) and exhibit close to complete exchange-rate pass-through into destination prices at all horizons. In contrast, large import-intensive firms tend to denominate their exports in foreign currencies, and especially in the US dollar, exhibiting a lower pass-through of the euro-destination exchange rate and a pronounced sensitivity to the dollar-destination exchangerate. Finally, the effects of foreign-currency price stickiness are still significant beyond the one-year horizon, but gradually dissipate in the long run, consistent with sticky price models of currency choice.
    Keywords: currency choice; exchange rate pass-through
    JEL: E31 F31 F41
    Date: 2020–10
  3. By: Jeanne, Olivier; Sandri, Damiano
    Abstract: We use a tractable model to show that emerging markets can protect themselves from the global financial cycle by expanding (rather than restricting) capital flows. This involves accumulating reserves when global liquidity is high to buy back domestic assets at a discount when global financial conditions tighten. Since the private sector does not internalize how this buffering mechanism reduces international borrowing costs, a social planner increases the size of capital flows beyond the laissez-faire equilibrium. The model also provides a role for foreign exchange intervention in less financially developed countries. The main predictions of the model are consistent with the data.
    Keywords: capital flow management; capital controls; Capital Flows; Foreign Exchange Reserves; sudden stop
    JEL: F31 F32 F36 F38
    Date: 2020–09
  4. By: Kaufmann, Christoph
    Abstract: This paper studies the role of international investment funds in the transmission of global financial conditions to the euro area using structural Bayesian vector auto regressions. While cross-border banking sector capital flows receded significantly in the aftermath of the global financial crisis, portfolio flows of investors actively searching for yield on financial markets world-wide gained importance during the post-crisis “second phase of global liquidity” (Shin, 2013). The analysis presented in this paper shows that a loosening of US monetary policy leads to higher investment fund inflows to equities and debt globally. Focussing on the euro area, these inflows do not only imply elevated asset prices, but also coincide with increased debt and equity issuance. The findings demonstrate the growing importance of non-bank financial intermediation over the last decade and have important policy implications for monetary and financial stability. JEL Classification: F32, F42, G15, G23
    Keywords: capital flows, international spillovers, Monetary policy, non-bank financial intermediation
    Date: 2021–05
  5. By: Hassan, Tarek Alexander; Zhang, Tony
    Abstract: This article reviews the literature on currency and country risk with a focus on its macroeconomic origins and implications. A growing body of evidence shows countries with safer currencies enjoy persistently lower interest rates and a lower required return to capital. As a result, they accumulate relatively more capital than countries with currencies international investors perceive as risky. Whereas earlier research focused mainly on the role of currency risk in generating violations of uncovered interest parity and other financial anomalies, more recent evidence points to important implications for the allocation of capital across countries, the efficacy of exchange rate stabilization policies, the sustainability of trade deficits, and the spillovers of shocks across international borders.
    Keywords: Capital Flows; carry trade; Country risk; currency risk; Forward premium puzzle; uncovered interest parity
    Date: 2020–09
  6. By: Filippou, Ilias; Rapach, David; Taylor, Mark P; Zhou, Guofu
    Abstract: We establish the out-of-sample predictability of monthly exchange rate changes via machine learning techniques based on 70 predictors capturing country characteristics, global variables, and their interactions. To guard against overfi tting, we use the elastic net to estimate a high-dimensional panel predictive regression and find that the resulting forecast consistently outperforms the naive no-change benchmark, which has proven difficult to beat in the literature. The forecast also markedly improves the performance of a carry trade portfolio, especially during and after the global financial crisis. When we allow for more complex deep learning models, nonlinearities do not appear substantial in the data.
    Keywords: carry trade; deep neural network; Elastic Net; exchange rate predictability
    JEL: C45 F31 F37 G11 G12 G15
    Date: 2020–09
  7. By: Kozhan, Roman; Taylor, Mark P; Xu, Qi
    Abstract: We empirically investigate the role of prospect theory in the foreign exchange market. Using the historical distribution of exchange rate changes, we construct a currency-level measure of prospect theory value and find that it negatively forecasts future currency excess returns. High prospect theory value currencies significantly underperform low prospect theory value currencies. The predictability is higher when arbitrage is limited and during periods of excess speculative demand of ir- rational traders. These findings are consistent with the hypothesis that investors mentally represent currencies by their historical distributions or charts and evaluate the distribution in the way described by prospect theory.
    Keywords: currency returns; foreign exchange; Limits to Arbitrage; prospect theory
    JEL: F31 G12 G15 G40
    Date: 2020–09

This nep-ifn issue is ©2021 by Vimal Balasubramaniam. It is provided as is without any express or implied warranty. It may be freely redistributed in whole or in part for any purpose. If distributed in part, please include this notice.
General information on the NEP project can be found at For comments please write to the director of NEP, Marco Novarese at <>. Put “NEP” in the subject, otherwise your mail may be rejected.
NEP’s infrastructure is sponsored by the School of Economics and Finance of Massey University in New Zealand.