nep-ifn New Economics Papers
on International Finance
Issue of 2022‒01‒17
four papers chosen by
Vimal Balasubramaniam
University of Oxford

  1. Dominant Currency Paradigm: A Review By Gita Gopinath; Oleg Itskhoki
  2. Sparse and Stable International Portfolio Optimization and Currency Risk Management By Raphael Burkhardt; Urban Ulrych
  3. News-Driven International Credit Cycles By Galip Kemal Ozhan
  4. Using Network-based Causal Inference to Detect the Sources of Contagion in the Currency Market By Katerina Rigana; Ernst-Jan Camiel Wit; Samantha Cook

  1. By: Gita Gopinath; Oleg Itskhoki
    Abstract: A handful of currencies, especially the US dollar, play a dominant role in international trade. We survey the active theoretical and empirical literature that documents patterns of currency use in global trade, the implications of dominant currencies for international transmission of shocks, exchange rate pass-through, expenditure switching, and optimal monetary policy. We describe advances in the endogenous currency choice literature including conditions for the emergence and persistence of dominant currency equilibria.
    JEL: F30 F40
    Date: 2021–12
  2. By: Raphael Burkhardt (University of Zurich - Department of Banking and Finance); Urban Ulrych (University of Zurich - Department of Banking and Finance; Swiss Finance Institute)
    Abstract: This paper introduces a sparse and stable optimization approach for a multi-currency asset allocation problem. We study the benefits of joint optimization of assets and currencies as opposed to the standard industry practice of managing currency risk via so-called currency overlay strategies. In our setting, a classical mean-variance problem in an international framework is augmented by several extensions that aim at reducing parameter uncertainty related to the input parameters and induce sparsity and stability of the asset and currency weights. These extensions integrate maximal net exposure to foreign currencies, shrinkage of the input parameters, and constraints on the norms of the asset- and currency-weight vectors. The empirical performance of the portfolio optimization strategies based on the proposed regularization techniques and the joint (i.e., asset and currency) optimization is tested out of sample. We demonstrate that the sparse and stable joint optimization approach consistently outperforms the standard currency overlay as well as the equally-weighted and the non-regularized global portfolio benchmarks net of transaction costs. This result shows that the common industry practice of employing currency overlay strategies is suboptimal and can be improved by a joint optimization over assets and currencies.
    Keywords: International Asset Allocation, Currency Risk Management, Currency Overlay, Shrinkage Estimation, Regularization, Mean-Variance Optimization
    JEL: C61 F31 G11 G15
    Date: 2022–01
  3. By: Galip Kemal Ozhan
    Abstract: How does news about future economic fundamentals affect within-country and cross-country credit allocation? How effective is unconventional policy when financial crises are driven by unfulfilled favorable news? I study these questions by employing a two-sector, two-country macroeconomic model with a financial sector in which financial crises are associated with occasionally binding leverage constraints. In response to positive news on the valuation of non-traded sector capital that turns out to be incorrect at a later date, the model captures the patterns of financial flows and current account dynamics in Spain between 2000-2010, including the changes in the sectoral allocation of bank credit and movements in cross-country borrowing during the boom and the bust. When there are unconventional policies by a common authority in response to unfulfilled favorable news, liquidity injections perform better in ameliorating the downturn than direct assets purchases from the non-traded sector.
    Keywords: Central bank research; Digital currencies and fintech
    JEL: E44 F32 F41 G15 G21
    Date: 2021–12
  4. By: Katerina Rigana; Ernst-Jan Camiel Wit; Samantha Cook
    Abstract: Contagion is an extremely important topic in finance. Contagion is at the core of most major financial crises, in particular the 2008 financial crisis. Although various approaches to quantifying contagion have been proposed, many of them lack a causal interpretation. We will present a new measure for contagion among individual currencies within the Foreign exchange market and show how the paths of contagion work within the Forex using causal inference. This approach will allow us to pinpoint sources of contagion and to find which currencies offer good options for diversification and which are more susceptible to systemic risk, ultimately resulting in feedback on the level of global systemic risk.
    Date: 2021–12

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