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New Advances in International Finance

Paper Session

Friday, Jan. 3, 2020 8:00 AM - 10:00 AM (PDT)

Manchester Grand Hyatt, Harbor A
Hosted By: American Finance Association
  • Chair: Pasquale Della Corte, Imperial College London

Importance of Transaction Costs for Asset Allocations in FX Markets

Thomas Maurer
,
University of Hong Kong
Luca Pezzo
,
University of New Orleans
Mark Taylor
,
Washington University-St. Louis

Abstract

Taking transaction costs into account in a mean-variance portfolio optimization in FX markets significantly improves the achievable after costs Sharpe ratio out-of-sample. The optimization reduces trading costs while the performance before costs is unaffected. The price impact due to large buy and sell orders or market illiquidity can turn popular currency trading strategies unprofitable, while our optimized portfolios remain profitable. This is because our optimized strategy is trading less aggressively. Rules-of-thumb to tackle transaction costs – such as (i) construct equally weighted strategies instead of optimized portfolios, (ii) trade at a low frequency, (iii) restrict trading to low cost assets, (iv) only rebalance if the current position is too far from the desired position, or (v) use expected returns net of costs in the optimization – are inefficient because there are adverse effects on the (before cost) performance which dominate the savings in transaction costs.

Origins of International Factor Structures

Zhengyang Jiang
,
Northwestern University
Robert Richmond
,
New York University

Abstract

We develop a model of the global production and consumption network and derive its implications for international comovements. Our model predicts that a simple measure of closeness, constructed only using bilateral data on production and consumption weights, explains numerous comovements in economic quantities and asset prices. We empirically measure closeness and show that countries that are closer in this network tend to have more correlated consumption growth, stock returns, and exchange rate movements. The network also generates factor structures in equity returns and exchange rates as found in the data. These results offer a network-based account of the origins of factor structures in international asset prices and economic quantities.

Government Policy Approval and Exchange Rates

Yang Liu
,
University of Hong Kong
Ivan Shaliastovich
,
University of Wisconsin-Madison

Abstract

Measures of U.S. government policy approval are strongly related to persistent fluctuations in the dollar exchange rate. Contemporaneous correlations between approval ratings and the dollar value reach 50% against the advanced economy currencies, in real and nominal terms, in levels and multi-year changes. High approval ratings further forecast a decline in the dollar risk premium, a persistent increase in economic growth, and a reduction in future economic volatility several years in the future. We provide an illustrative economic model to interpret our empirical evidence. In the model, policy valuations are forward-looking and reflect net contributions of policy to economic growth. Policy valuations (approvals) increase at times of high policy-related growth and low policy-related uncertainty, which are the times of a strong dollar and low dollar risk premium.

U.S. Equity Tail Risk and Currency Risk Premia

Zhenzhen Fan
,
Nankai University
Juan M. Londono
,
Federal Reserve Board
Xiao Xiao
,
Erasmus University Rotterdam

Abstract

We find that an option-based U.S. equity tail risk factor is priced in the cross section of currency returns. Currencies highly exposed to this factor offer a low risk premium because they hedge against U.S. tail risk. In a reduced-form model, we show that a long-short portfolio that buys currencies with high U.S. equity tail beta and shorts those with low tail beta extracts the global component embedded in the U.S. tail risk factor. Inspired by the model, we construct a novel global tail risk factor from currency returns. This factor along with the dollar factor explains a large portion of the cross-sectional variation in the currency carry and momentum portfolios and outperforms other popular models.
Discussant(s)
Bernard Dumas
,
INSEAD
Rosen Valchev
,
Boston College
Adrien Verdelhan
,
Massachusetts Institute of Technology
Mikhail Chernov
,
University of California-Los Angeles
JEL Classifications
  • G1 - General Financial Markets