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Exchange Rates and International Capital Market

Paper Session

Saturday, Jan. 6, 2018 10:15 AM - 12:15 PM

Loews Philadelphia, Regency Ballroom C1
Hosted By: American Finance Association
  • Chair: Vivian Yue, Emory University

Currency Manipulation

Tarek A. Hassan
,
Boston University, NBER, and CEPR
Thomas M. Mertens
,
Federal Reserve Bank of San Francisco
Tony Zhang
,
University of Chicago

Abstract

We propose a novel, risk-based transmission mechanism for the effects of currency manipulation: policies that systematically induce a country’s currency to appreciate in bad times lower its risk premium in international markets and, as a result, lower the country’s risk-free interest rate and increase domestic capital accumulation and wages. Currency manipulations by large countries also have external effects on foreign interest rates and capital accumulation. Applying this logic to policies that lower the variance of the bilateral exchange rate relative to some target country (“currency stabilization”), we find that a small economy stabilizing its exchange rate relative to a large economy increases domestic capital accumulation and wages. The size of this effect increases with the size of the target economy, offering a potential explanation why the vast majority of currency stabilizations in the data are to the U.S. dollar, the currency of the largest economy in the world. A large economy (such as China) stabilizing its exchange rate relative to a larger economy (such as the U.S.) diverts capital accumulation from the target country to itself, increasing domestic wages, while decreasing wages in the target country.

Business Cycles and Currency Returns

Steven Riddiough
,
University of Melbourne
Lucio Sarno
,
City University London

Abstract

We find a strong link between currency returns and the relative strength of the business cycle. Buying currencies of strong economies and selling currencies of weak economies generates high returns in both the cross-section and time-series of countries. These returns stem primarily from spot exchange rate predictability, are uncorrelated with common currency strategies, and cannot be understood using traditional risk factors. We also show that a business cycle factor implied by our results is priced in a broad cross-section of currency excess returns. These results contrast with a vast literature that detects no linkages between currency fluctuations and macroeconomic variables.

The Volatility of International Capital Flows and Foreign Assets

Winston Wei Dou
,
University of Pennsylvania
Adrien Verdelhan
,
Massachusetts Institute of Technology

Abstract

This paper presents a two-good, two-country real model that replicates the basic stylized facts on equity excess returns and real interest rates. In the model, markets are incomplete. In each country, workers cannot participate in financial markets whereas investors trade domestic and foreign stocks, as well as an international bond. The investors’ asset positions are subject to a borrowing constraint, along with a short-selling constraint on equity. Foreign and domestic agents differ in their elasticity of inter
temporal substitution and in their risk-aversion. A time-varying probability of a global disaster implies time-varying risk premia in asset markets, and therefore large and time-varying expected valuation effects on international asset positions. The model highlights the role of market incompleteness and heterogeneity across countries in accounting for the volatility of equity and debt international capital flows.

Gravity in FX R2: Understanding the Factor Structure in Exchange Rates

Robert Richmond
,
New York University
Hanno Lustig
,
Stanford University

Abstract

We relate the risk characteristics of currencies to country characteristics. Exchange rates strongly co-vary against their base currency. We show that exposure to this common covariation is increasing in the distance of a country from the base country. For example, the base currency beta of the CHF/USD exchange rate on the dollar factor is determined by the distance between Switzerland and the United States. Shared language, legal origin, a shared border, resource similarity and colonial linkages significantly lower the bilateral exchange rate betas.
Discussant(s)
Matteo Maggiori
,
Harvard University
Riccardo Colacito
,
University of North Carolina-Chapel Hill
Edith Liu
,
Federal Reserve Board
Nikolai Roussanov
,
University of Pennsylvania
JEL Classifications
  • G1 - General Financial Markets