Table of Contents

Series Page

Title Page

Copyright

Dedication Page

Preface

Contributors

Part I: Overview

Chapter 1: Foreign Exchange Market Structure, Players, and Evolution

1.1 Introduction

1.2 Geography and Composition of Currency Trading

1.3 Players and Information in FX Market

1.4 Electronic Trading Revolution in FX Market

1.5 Survey of Multibank FX Platforms

1.6 Summary

1.7 Glossary

1.8 Acknowledgments

References

Chapter 2: Macro Approaches to Foreign Exchange Determination

2.1 Introduction

2.2 Models of the Nominal Exchange Rate

2.3 Real Models of the Real Exchange Rate

2.4 New Directions in Exchange-Rate Modeling

2.5 Conclusions

2.6 Acknowledgments

References

Chapter 3: Micro Approaches to Foreign Exchange Determination

3.1 Introduction

3.2 Perspectives on Spot-Rate Dynamics

3.3 Currency Trading Models and their Implications

3.4 Exchange Rates, Order Flows, and the Macro Economy

3.5 Conclusion

3.6 Appendix

3.7 Acknowledgment

References

Chapter 4: The Exchange Rate in a Behavioral Finance Framework

4.1 Introduction

4.2 Exchange Rate Puzzles

4.3 A Prototype Behavioral Model of the Foreign Exchange Market

4.4 Conclusion

References

Chapter 5: The Evolution of Exchange Rate Regimes and Some Future Perspectives

5.1 Introduction

5.2 A Brief History of Currency Regimes

5.3 Performance of the Laisser-Faire Exchange Rate System, 1973–2010

5.4 Trends in Currency Use

5.5 Prospects for the Future

5.6 Concluding Comments

5.7 Appendix A: A Formal Test of Hollowing Out

References

Part II: Exchange Rate Models and Methods

Chapter 6: Purchasing Power Parity in Economic History

6.1 Introduction

6.2 Categorization of Purchasing-Power-Parity Theories

6.3 Historical Application of PPP: Premodern Periods

6.4 Techniques of Testing PPP Theory in Economic-History Literature

6.5 Price Variable in PPP Computations

6.6 Modern Period: Testing of PPP

6.7 Analysis of U.S. Return to Gold Standard in 1879

6.8 Establishment and Assessment of a Fixed Exchange Rate in Interwar Period

6.9 Conclusions

References

Chapter 7: Purchasing Power Parity in Tradable Goods

7.1 Introduction

7.2 The LOP and Price Indices

7.3 Empirical Evidence on the LOP

7.4 Purchasing Power Parity

7.5 Aggregating from the LOP to PPP: What Can We Infer?

7.6 Conclusion and Implications

7.7 Appendix: TAR modeling

7.8 Acknowledgments

References

Chapter 8: Statistical and Economic Methods for Evaluating Exchange Rate Predictability

8.1 Introduction

8.2 Models for Exchange Rate Predictability

8.3 Statistical Evaluation of Exchange Rate Predictability

8.4 Economic Evaluation of Exchange Rate Predictability

8.5 Combined Forecasts

8.6 Empirical Results

8.7 Conclusion

8.8 Appendix A: The Bootstrap Algorithm

8.9 Acknowledgments

References

Chapter 9: When Are Pooled Panel-Data Regression Forecasts of Exchange Rates More Accurate than the Time-Series Regression Forecasts?

9.1 Introduction

9.2 Panel Data Exchange Rate Determination Studies

9.3 Asymptotic Consequences of Pooling

9.4 Monte Carlo Study

9.5 An Illustration with Data

9.6 Conclusions

References

Chapter 10: Carry Trades and Risk

10.1 Introduction

10.2 The Carry Trade: Basic Facts

10.3 Pricing the Returns to the Carry Trade

10.4 Empirical Findings

10.5 Time-Varying Risk and Rare Events

10.6 Conclusion

10.7 Acknowledgments

References

Chapter 11: Currency Fair Value Models

11.1 Introduction

11.2 Models/Taxonomy

11.3 Implementation Choices and Model Characteristics

11.4 Conclusion

11.5 Acknowledgments

References

Chapter 12: Technical Analysis in the Foreign Exchange Market

12.1 Introduction

12.2 The Practice of Technical Analysis

12.3 Studies of Technical Analysis in the Foreign Exchange Market

12.4 Explaining The Success of Technical Analysis

12.5 The Future of Research on Technical Analysis

12.6 Conclusion

12.7 Acknowledgments

References

Chapter 13: Modeling Exchange Rates with Incomplete Information

13.1 Introduction

13.2 Basic Monetary Model

13.3 Information Heterogeneity

13.4 Model Uncertainty

13.5 Infrequent Decision Making

13.6 Conclusion

13.7 Acknowledgments

References

Chapter 14: Exchange Rates in a Stochastic Discount Factor Framework

14.1 Introduction

14.2 Exchange Rates and Stochastic Discount Factors

14.3 Empirical Evidence

14.4 Models

14.5 Conclusion

References

Chapter 15: Volatility and Correlation Timing in Active Currency Management

15.1 Introduction

15.2 Dynamic Models for Volatility and Correlation

15.3 The Economic Value of Volatility and Correlation Timing

15.4 Parameter Uncertainty in Bayesian Asset Allocation

15.5 Model Uncertainty

15.6 Empirical Results

15.7 Conclusion

15.8 Appendix A: Univariate Models for Volatility Timing

15.9 Appendix B: Parameter Uncertainty and the Predictive Density

15.10 Acknowledgments

References

Part III: FX Markets and Products

Chapter 16: Active Currency Management Part I: Is There a Premium for Currency Investing (Beta)

16.1 Introduction

16.2 Beta in the Foreign Exchange Markets

16.3 Multiple Forms of FX Beta

16.4 Carry FX Indices from Banks

16.5 Trend-Following FX Indices from Banks

16.6 Conclusion

References

Chapter 17: Active Currency Management Part II: Is There Skill or Alpha in Currency Investing?

17.1 Introduction

17.2 Alternative Currency Management Mandates

17.3 Benchmarks for Currency Fund Management

17.4 Empirical Evidence with the Barclay Currency Traders Index and Individual Fund Managers

17.5 Empirical Evidence: Fund Managers on the DB FX Select Platform

17.6 Conclusions and Investment Implications

References

Chapter 18: Currency Hedging for International Bond and Equity Investors

18.1 Introduction

18.2 Overview of Empirical Hedging Studies

18.3 Return and Volatility Impact of Currency Hedging

18.4 Hedge Instruments—Currency Forwards versus Options

18.5 Managing Tracking Error in Forward Hedges

18.6 Conclusions

References

Chapter 19: FX Reserve Management

19.1 FX Reserve Management

19.2 FX Reserve Uses

19.3 FX Reserve Sources

19.4 Objectives of Reserves Management

19.5 Techniques of Reserve Management

19.6 Historical Perspective

19.7 What Assets Do Central Banks Hold?

19.8 Constraints

19.9 External Managers

19.10 Costs of Accumulation and Holding of Reserves

19.11 Diversification

19.12 Challenges to Diversification and Size of Reserves

19.13 Changing Role of the Dollar as the International Reserve Currency

19.14 Reserve Management if the Dollar is Replaced as the Reserve Currency

19.15 Conclusion

19.16 Acknowledgments

References

Chapter 20: High Frequency Finance: Using Scaling Laws to Build Trading Models

20.1 Introduction

20.2 The Intrinsic Time Framework

20.3 Scaling Laws

20.4 The Scale of Market Quakes

20.5 Trading Models

20.6 Conclusion

20.7 Acknowledgments

References

Chapter 21: Algorithmic Execution in Foreign Exchange

21.1 Introduction

21.2 Key Components of an Algorithmic Execution Framework

21.3 Types of Algorithms

21.4 What Execution Strategies are Most Effective?

21.5 Looking Forward

21.6 Appendix A

References

Chapter 22: Foreign Exchange Strategy Based Products

22.1 Introduction

22.2 Evolution of the Foreign Exchange Market

22.3 Foreign Exchange Investable Indices and Strategy-Based Products

22.4 Conclusion

References

Chapter 23: Foreign Exchange Futures, Forwards, and Swaps

23.1 Introduction

23.2 Market Basics and Size

23.3 Dislocations of the FX and Cross-Currency Swap Markets under Financial Crises

23.4 Conclusion

23.5 Acknowledgments

References

Chapter 24: FX Options and Volatility Derivatives: An Overview from the Buy-Side Perspective

24.1 Introduction

24.2 Why Would One Bother With an Option?

24.3 Market for FX Options

24.4 Volatility

24.5 FX Options from the Buy-Side Perspective

24.6 Acknowledgment

References

Part IV: FX Markets and Policy

Chapter 25: A Common Framework for Thinking about Currency Crises

25.1 Introduction

25.2 The KFG Model

25.3 Extensions

25.4 Empirical Work

25.5 Conclusion

References

Chapter 26: Official Intervention in the Foreign Exchange Market

26.1 Introduction

26.2 Official FX Interventions and Reserve Accumulation: Stylized Facts, Motives, and Effects

26.3 Empirical Evidence on the Effectiveness of Official FX Interventions

26.4 Conclusions

26.5 Acknowledgements

References

Chapter 27: Exchange Rate Misalignment—The Case of the Chinese Renminbi

27.1 Introduction

27.2 Background

27.3 Undervalued or Overvalued

27.4 Concluding Remarks

27.5 Acknowledgments

References

Chapter 28: Choosing an Exchange Rate Regime

28.1 Five Advantages of Fixed Exchange Rates

28.2 Econometric Evidence on the Bilateral Trade Effects of Currency Regimes

28.3 Five Advantages of Floating Exchange Rates

28.4 How to Weigh Up the Advantages of Fixing Versus Floating

28.5 Country Characteristics That Should Help Determine the Choice of Regime

28.6 Alternative Nominal Anchors

References

Index

Wiley Series

Copyright 2012 by John Wiley & Sons, Inc. All rights reserved

Published by John Wiley & Sons, Inc., Hoboken, New Jersey

Published simultaneously in Canada

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Library of Congress Cataloging-in-Publication Data:

Handbook of exchange rates / [edited by] Jessica James, Ian W. Marsh, Lucio Sarno.

pages cm. – (Wiley handbooks in financial engineering and econometrics ; 2)

Includes bibliographical references and index.

ISBN 978-0-470-76883-9

1. Foreign exchange rates. 2. Foreign exchange. I. Sarno, Lucio.

II. James, Jessica, 1968– III. Marsh, Ian W., 1966–

HG3810.H35 2012

332.4′56–dc23

2011052323

For my children Zach and Miriam, my constant sources

of inspiration!

Jessica James

To my wonderful wife Michela

Ian W. Marsh

To my fantastic wife Julia

Lucio Sarno

Preface

The Foreign Exchange market, as we know, was born in the 1970s. To us in the second decade of the third millennium, mainly accustomed to freely floating and convertible currencies, the events that led to its birth would seem almost incredible. It is huge news when a government, via its central bank, intervenes to shift its currency or keep it stable. But from the end of World War II to the mid-1970s, pegs and interventions were the norm for almost all currencies.

The post war era gave us the Bretton Woods agreement that set the United States as the world's reserve currency and pegged most others to it. The United States was backed by gold, and the stability that this system brought enabled trade flows to enormously grow worldwide. This was deliberate; in the preceding decades, the architects of the system had seen how economic stresses could lead countries to war and were driven by a desire to promote trade and allow the world economy to grow.

However, the Vietnam war brought a growing US trade deficit and a drift of the alignment of the United States and the US dollar with the rest of the world. Pressure grew on the exchange rates and one by one, led by the Japanese yen, the currency became freely convertible and floating. By 1976, the gold standard was no more present and the majority of the world's currencies had the form we know today.

From that not-so-auspicious beginning grew the world's largest market. Today, according to the 2010 BIS report, currencies to the value of over US$4 trillion are traded each working day in global markets. The total value of global equity is a fraction of this amount. In most countries, the traded volume of the currency vastly exceeds the total amount of government debt. Foreign exchange has indeed come of age.

But what is it like, compared to other rates? It is not an interest rate. An interest rate is highly predictable and stable between close to zero, and perhaps exceptionally 15%. Outside these ranges, interest rates historically do not last long; high rates are often followed by spiralling hyperinflations, and negative rates do not occur without anomalous market stresses. It is not an equity, which has a floor at zero and is at least expected to appreciate with inflation.

There is a symmetry to foreign exchange, which is lacking in other market rates. One is “long” or “short” of an equity; in foreign exchange to be long of one currency is to be short of another. It is a rate of exchange and not an ownership of an asset. It has no floor or ceiling, no particular “stable region.” As befits the largest global market, it is also the easiest and cheapest to trade in, with transactions often costing just a single basis point—1% of 1%—in bid-offer spread.

How and why has it grown to such a size? Partly, it is the nature of the beast and the way it is traded. Most foreign exchange transactions are done on a margined basis, with the principal amounts being notional only. Thus, for a simple forward trade of 1 month's duration, where a rate of exchange is locked in for 1 month ahead, no capital is exchanged at the start. At the end, the difference between the agreed rate and the market rate is paid out, scaled by the notional amount of the deal. This is usually at most a few percent of this notional amount. So one can see that it is unnecessary to actually own a sum of money equal to the notional amount—it is more of a scaling factor to the deal. Hence, the notional flows in the market can be very large relative to a smaller capital base.

Another reason for the size of the foreign exchange flows is that speculative trades, which have grown vastly in size and number over the last few years, are usually leveraged. The foreign exchange market is somewhat less volatile than the equity or commodity market, and so to generate comparable profits, profit seeking traders usually apply a multiplier to the notional amount. The last decade has seen the development of foreign exchange as an asset class, where structures suitable for investors are created around foreign exchange transactions. These often utilize large notional amounts to generate returns.

These additions increase an already considerable bulk of foreign exchange trades in the market. One critical activity made possible by the advent of floating exchange rates is hedging. Overseas investments can have their value drastically altered by fluctuations in the foreign exchange rates; hedges allow investors and corporates to immunize their portfolios and cashflows against these variations. Thus the growth of overseas investment has itself driven the volume of foreign exchange transactions higher; the investments, particularly less volatile fixed income instruments, will be significantly affected by foreign exchange movements unless they are hedged.

What are the instruments that make up this flow? The vast majority are spot and forward transactions, but the option market is also deep and liquid. This market came into its own in 1983 when Garman and Kolhagen published the formula for an option on a foreign exchange rate. Additionally, a vast variety of structures may be constructed, which allow investors or corporates to eliminate or transform risks, or gain exposure to specific areas and events.

Why do we need a Handbook of Exchange Rates? In part because it is so important, and in part because it is evolving so rapidly. In the last 5 years, we have seen the growth of foreign exchange as an asset class, which 10 years ago was the exclusive property of large trading floors and a few fund managers. Most large investors will now have a portion of their risk allocated to active strategies, which deliver fundlike returns derived from positioning themselves in the foreign exchange market. Another significant change is the growth of correlation and volatility derivatives. The correlation of rates has become a traded quantity, allowing a remarkably subtle set of risks and rewards to be accessed. The fascinating dynamics of high frequency data are now largely understood via scaling laws, to the extent that co-location—the siting of trading hubs close to exchanges—is becoming an issue; the speed of light has become a limiting factor in foreign exchange trading.

Another fascinating development is strongly connected with the correlation properties of foreign exchange rates. In floating emerging markets, the majority of foreign exchange rates are closely connected with their equity markets for obvious reasons. So high is this correlation that one can replicate emerging market equity indices to good accuracy using only foreign exchange rates—with their greater liquidity and low trading costs. Other interesting correlations are those between the Japanese yen or Australian dollar to the world's equity markets. So strong is the negative (in the case of the Yen) or positive (the Australian dollar) correlation that currency positions are often used to hedge equity drawdowns. So the foreign exchange market is being used to proxy for other rates. Its liquidity and depth make this attractive, though market stresses could bring an end to some of these useful correlations.

The Handbook is designed to span this extensive subject, with experts in the different areas contributing to each section. In planning the book, we drew up a list of the key subjects deserving of a chapter and against each we wrote the name of the key people in that topic. In almost every case, to our delight, those people accepted our invitation to contribute. As a result, the chapters have been written by leading specialists in their fields, often with extensive experience in academia and/or professional practice. Each chapter then benefitted from the feedback of at least one anonymous referee and at least one coeditor, and most authors kindly also acted as referees.

The initial section “Overview” covers structure, regimes, and general underlying behaviors. Part 2 covers models and methods, focussing on the predictability—or lack of it—of foreign exchange rates. In Part 3, we go to the practitioner side of the subject to cover hedging, active management, high frequency trading, and products. Part 4 wraps up with a look at policy and a framework for analyzing currency crises. The chapters are mainly in the form of self-contained surveys, and trace the key developments in a well-defined topic with specific reference to the relevant research frontier. Some contributions also present new empirical findings, especially where competing paradigms are evaluated. So rapid has the evolution of this market been, that it would not be surprising if in a few years there are many new chapters to add! Alternatively, market stresses and political crises can influence foreign exchange rates to an enormous extent. It is easy to forget that our current regime of floating market determined rates is recent, and by no means the norm in a historical context. The foreign exchange market is a fascinating subject, which never stops evolving.

We owe a debt of gratitude to many people for helping us bring this project to a successful conclusion: the contributing authors, for the high quality of their chapters; the many anonymous referees who provided, without exception, valuable feedback to the authors; and Chiara Banti who collated the chapters and worked very hard to copy edit the first draft of the Handbook. Needless to say, without their help, we would never have completed this project.

Jessica James

Ian W. Marsh

Contributors

Saeed Amen, Nomura, London, UK

Naohiko Baba, Goldman Sachs Japan Co. Ltd., Tokyo, Japan

Philippe Bacchetta, Department of Economics, University of Lausanne, Lausanne, Switzerland; CEPR

Craig Burnside, Department of Economics, Duke University, Durham, NC, USA; CEPR; NBER

Gino Cenedese, Bank of England, London, UK

Yin-Wong Cheung, Department of Economics and Finance, City University of Hong Kong, Hong Kong

Menzie Chinn, Robert M. La Follette School of Public Affairs; Department of Economics, University of Wisconsin-Madison, Madison, WI, USA; NBER

James E. Dalton, CitiFX Intelligent Orders, Citigroup, London, UK

Paul De Grauwe, Department of Economics, University of Leuven, Leuven, Belgium

Pasquale Della Corte, Imperial College, London, UK

Alexandre Dupuis, Olsen Ltd., Zurich, Switzerland; Centre for Computational Finance and Economic Agents (CCFEA), University of Essex, UK

Martin D. D. Evans, Department of Economics, Georgetown University, Washington DC, USA; NBER

Robert Flood, University of Notre Dame, Notre Dame, IN, USA

Jeffrey A. Frankel, Kennedy School of Government, Harvard University, Cambridge, MA, USA; NBER

Marcel Fratzscher, European Central Bank, Frankfurt/Main, Germany

Kristjan Kasikov, CitiFX Quantitative Investor Solutions, Citigroup, London, UK

Geoffrey Kendrick, Nomura, London, UK

Michael R. King, Richard Ivey School of Business, University of Western Ontario, Canada

Richard M. Levich, Finance Department, Stern School of Business, New York University, New York, NY, USA

Hanno Lustig, UCLA Anderson School of Management, Los Angeles, CA, USA; NBER

Nancy Marion, Dartmouth College, Hanover, NH, USA

Nelson Mark, Department of Economics, University of Notre Dame, Notre Dame, IN, USA; NBER

Ian W. Marsh, Cass Business School, London, UK

Paul R. Masson, Rotman School of Management, University of Toronto, Toronto, Canada

Christopher J. Neely, Research Department, Federal Reserve Bank of St. Louis, St. Louis, MI, USA

Lawrence H. Officer, University of Illinois at Chicago, Chicago, IL, USA

Richard B. Olsen, Olsen Ltd., Zurich, Switzerland; Centre for Computational Finance and Economic Agents (CCFEA), University of Essex, UK

Carol Osler, Brandeis International Business School, Brandeis University, Waltham, MA, USA

Frank Packer, Bank for International Settlements, Basel, Switzerland

Evgenia Passari, Cass Business School, London, UK

Michael J. Paulus, Hongkong and Shanghai Banking Corporation (HSBC), Hong Kong

Momtchil Pojarliev, Hathersage Capital Management LLC, South Norwalk, CT, USA

Dagfinn Rime, Research Department, Norges Bank, Oslo, Norway; Norwegian University of Science and Technology

Pablo Rovira Kaltwasser, University of Leuven, Leuven, Belgium

Yuji Sakurai, UCLA Anderson School of Management, Los Angeles, CA, USA

Lucio Sarno, Cass Business School, London, UK; CEPR

Aysu Secmen, CitiFX Quantitative Investor Solutions, Citigroup, New York, USA

Thomas Stopler, Goldman Sachs, London, UK

Donggyu Sul, University of Texas, Dallas, TX, USA

Oleg Svirschi, Record Currency Management, London, UK

Ilias Tsiakas, Department of Economics and Finance, University of Guelph, Guelph, Ontario, Canada

Eric van Wincoop, Department of Economics, University of Virginia, VA, USA; NBER

Adrien Verdelhan, Department of Finance, MIT Sloan School of Management, Cambridge, MA, USA; NBER

Paul A. Weller, Tippie College of Business, University of Iowa, Iowa City, IA, USA

Juan Yepez Albornoz, Department of Economics, University of Notre Dame, Notre Dame, IN, USA

Part I

OVERVIEW

Chapter 1

Foreign Exchange Market Structure, Players, and Evolution

Michael R. King

Richard Ivey School of Business, University of Western Ontario

Carol Osler

Brandeis International Business School, Brandeis University

Dagfinn Rime

Norges Bank, Norwegian University of Science and Technology

1.1 Introduction

It would be hard to overstate the importance of exchange rates for the world economy. They affect output and employment through real exchange rates. They affect inflation through the cost of imports and commodity prices. They affect international capital flows through the risks and returns of different assets. Exchange rates are justifiably a major focus for policymakers, the public, and, of course, the media.

To understand exchange rates, it is essential to know how these prices are determined. This chapter describes the FX market and presents new evidence on recent trends, thereby setting the stage for the rest of the handbook. It presents stylized facts on the market's size and composition. It then describes more closely the motives, incentives, and constraints of the major players. Trading is a search problem, and the constraints and costs related to this search are affected by the structure of the market. Our starting point is that the exchange rates are primarily driven by new information about economic fundamentals. In this light, we review which agents bring information to the market and exactly how their information becomes embedded in the market price.

The chapter describes the momentous changes in trading practices and market structure which have taken place over the recent decades. It concludes by presenting new evidence on some of the most recent technological advances. Twenty-five years ago, most FX trading involved the telephone and all trading involved institutions: individuals were essentially shut out. Trading was opaque, there was a sharp division between interdealer trading and dealer–customer trading, and market concentration among dealers was low.

Today, only the least liquid corners of the FX market can still be described this way. In the liquid markets, telephones are obsolete. New electronic trading platforms have streamlined trade processing and settlement, reduced operational risks, and lowered trading costs. Lower trading costs have enabled the participation of retail traders and the adoption of new strategies such as high frequency trading—a form of computer-automated trading that relies on high execution speeds to make profits from small price movements. Since streaming real-time prices are now available to virtually all participants, these markets are now regarded as transparent. On some of the new platforms, any trader can provide liquidity, so the division between dealers and their most sophisticated customers is, at times, ambiguous. To remain competitive, the major dealing banks have made heavy investments in software and hardware, which has led to sharply higher concentration among market makers.

1.2 Geography and Composition of Currency Trading

Given the pervasive influence of exchange rates, it is no surprise that the dollar value of trading activity in spot and forward FX market dwarfs most other economic measures (BIS, 2010). With daily average turnover estimated at $2.0 trillion, the market is 36 times larger than the combined exports and imports for the world's 35 largest economies, 16 times their combined GDP, and roughly 10 times exchange-traded equity turnover.

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