Title Details

JESSICA JAMES, PhD, is a Managing Director and Co-Head of the Quantitative Solution Team at Commerzbank in London, where she is responsible for FX client risk advisory. She has published on the topics of credit derivatives and total return swaps and is the coauthor of Interest Rate Modelling (Wiley).

IAN W. MARSH, PhD, is Professor of Finance in the Cass Business School at City University London. Dr. Marsh has extensive consulting experience with companies including JPMorgan Chase, Morley Fund Managment, and the Royal Bank of Scotland. He currently focuses his research on credit risk transfer markets and the foreign exchange market.

LUCIO SARNO, PhD, is Associate Dean, Head of Faculty, and Professor of Finance in the Cass Business School at City University London. Dr. Sarno has extensive industry experience in consulting and trading foreign exchange for several major asset management companies and has contributed to policy, training, and research for the International Monetary Fund, the European Central Bank, and the World Bank.

Preface xxiii

Contributors xxvii

part one Overview

1 Foreign Exchange Market Structure, Players, and Evolution 3

1.1 Introduction, 3

1.2 Geography and Composition of Currency Trading, 4

1.2.1 Which Currencies are Traded? 6

1.2.2 What Instruments are Traded? 9

1.2.3 How is Trading Regulated? 9

1.3 Players and Information in FX Markets, 11

1.3.1 Who Needs Liquidity? 12

1.3.2 Who Provides Liquidity? 15

1.3.3 Asymmetric Information and Exchange Rate Determination, 19

1.4 Electronic Trading Revolution in FX Markets, 21

1.4.1 The Telephone Era, 22

1.4.2 The Rise of the Computer, 22

1.4.3 Recent Developments in Electronic Trading, 30

1.5 Survey of Multibank FX Platforms, 35

1.6 Summary, 38

Glossary, 39

Acknowledgments, 41

References, 42

2 Macro Approaches to Foreign Exchange Determination 45

2.1 Introduction, 45

2.2 Models of the Nominal Exchange Rate, 46

2.2.1 The Monetary Model, 46

2.2.2 Portfolio Balance Models, 49

2.2.3 Empirical Evidence, 51

2.3 Real Models of the Real Exchange Rate, 54

2.3.1 Purchasing Power Parity, 55

2.3.2 Balassa–Samuelson and Productivity-Based Models, 56

2.3.3 Two-Good Models, 59

2.4 New Directions in Exchange-Rate Modeling, 60

2.4.1 Taking Reaction Functions Seriously, 60

2.4.2 The Impact of Financial Globalization, 63

2.4.3 The Risk Premium and Order Flow, 64

2.5 Conclusions, 65

Acknowledgments, 65

References, 66

3 Micro Approaches to Foreign Exchange Determination 73

3.1 Introduction, 73

3.2 Perspectives on Spot-Rate Dynamics, 74

3.2.1 Decomposition of Depreciation Rates, 74

3.2.2 Macro- and Microperspectives, 77

3.3 Currency Trading Models and their Implications, 80

3.3.1 The Portfolio Shifts Model, 81

3.3.2 Empirical Implications, 88

3.4 Exchange Rates, Order Flows, and the Macro Economy, 95

3.4.1 A Micro-Based Macro model, 96

3.4.2 Empirical Implications, 100

3.5 Conclusion, 105

Appendix, 105

3.6 Acknowledgment, 108

References, 108

4 The Exchange Rate in a Behavioral Finance Framework 111

4.1 Introduction, 111

4.1.1 Mainstream Exchange Rate Models, 111

4.1.2 Away from the Mainstream, 113

4.2 Exchange Rate Puzzles, 114

4.2.1 Disconnect Puzzle and Excess Volatility Puzzle, 114

4.2.2 Unit Root Property, 115

4.2.3 Volatility Clustering, 118

4.2.4 Fat-Tailed Distributed Exchange Rate Returns, 119

4.3 A Prototype Behavioral Model of the Foreign Exchange Market, 122

4.4 Conclusion, 127

References, 129

5 The Evolution of Exchange Rate Regimes and Some Future Perspectives 133

5.1 Introduction, 133

5.2 A Brief History of Currency Regimes, 135

5.3 Performance of the Laisser-Faire Exchange Rate System, 1973–2010, 138

5.3.1 Market Discipline, 139

5.3.2 Economic Policy Coordination, 140

5.3.3 Integration of Emerging Market Countries into the Global Economy, 140

5.4 Trends in Currency Use, 141

5.4.1 Global Imbalances and the Financial Crisis of 2007–2009, 143

5.5 Prospects for the Future, 144

5.5.1 The Current System, 144

5.5.2 Toward a more Managed International Monetary System? 146

5.5.3 How and When Will Reform Occur? 150

5.5.4 A Global Nominal Anchor? 151

5.6 Concluding Comments, 153

Appendix A: A Formal Test of Hollowing Out, 154

References, 156

part two Exchange Rate Models and Methods

6 Purchasing Power Parity in Economic History 161

6.1 Introduction, 161

6.2 Categorization of Purchasing-Power-Parity Theories, 162

6.3 Historical Application of PPP: Premodern Periods, 163

6.3.1 Ancient Period, 163

6.3.2 Medieval Period, 164

6.3.3 Sixteenth-Century Spain, 165

6.4 Techniques of Testing PPP Theory in Economic-History Literature, 165

6.4.1 Comparative-Static Computation, 165

6.4.2 Regression Analysis, 165

6.4.3 Testing for Causality, 165

6.4.4 Nonstationarity and Spurious Regression, 166

6.4.5 Testing for Stationarity, 167

6.4.6 Cointegration Analysis, 167

6.5 Price Variable in PPP Computations, 168

6.6 Modern Period: Testing of PPP, 169

6.6.1 Early North America, 169

6.6.2 Bullionist Periods, 170

6.6.3 Floating Rates—Second-Half of Nineteenth Century, 171

6.6.4 Classic Metallic Standards, 172

6.6.5 World War I, 172

6.6.6 Floating Rates—1920s, 173

6.6.7 1930s, 175

6.6.8 Interwar Period, 175

6.6.9 Spain—Long Term, 176

6.6.10 Guatemala—Long Term, 176

6.7 Analysis of U.S. Return to Gold Standard in 1879, 177

6.8 Establishment and Assessment of a Fixed Exchange Rate in Interwar Period, 177

6.8.1 United Kingdom, 177

6.8.2 France, 179

6.9 Conclusions, 180

References, 181

7 Purchasing Power Parity in Tradable Goods 189

7.1 Introduction, 189

7.2 The LOP and Price Indices, 190

7.3 Empirical Evidence on the LOP, 194

7.3.1 Early Tests of the LOP, 194

7.3.2 The Border Effect, 194

7.3.3 Barriers to Arbitrage and Nonlinearities, 195

7.3.4 The Tradable Versus Nontradable Goods Dichotomy, 198

7.3.5 The Aggregation Bias and Micro Price Studies, 199

7.4 Purchasing Power Parity, 200

7.4.1 Transitory and Structural Disparities from Parity, 203

7.5 Aggregating from the LOP to PPP: What Can We Infer? 205

7.5.1 An Eyeball Analysis of PPP, 207

7.6 Conclusion and Implications, 213

Appendix: TAR Modeling, 214

Acknowledgments, 215

References, 215

8 Statistical and Economic Methods for Evaluating Exchange Rate Predictability 221

8.1 Introduction, 221

8.2 Models for Exchange Rate Predictability, 224

8.2.1 A Present Value Model for Exchange Rates, 224

8.2.2 Predictive Regressions, 226

8.3 Statistical Evaluation of Exchange Rate Predictability, 228

8.4 Economic Evaluation of Exchange Rate Predictability, 231

8.4.1 The Dynamic FX Strategy, 231

8.4.2 Mean-Variance Dynamic Asset Allocation, 231

8.4.3 Performance Measures, 232

8.4.4 Transaction Costs, 234

8.5 Combined Forecasts, 235

8.6 Empirical Results, 237

8.6.1 Data on Exchange Rates and Economic Fundamentals, 237

8.6.2 Predictive Regressions, 242

8.6.3 Statistical Evaluation, 244

8.6.4 Economic Evaluation, 249

8.7 Conclusion, 256

Appendix A: The Bootstrap Algorithm, 259

Acknowledgments, 260

References, 260

9 When Are Pooled Panel-Data Regression Forecasts of Exchange Rates More Accurate than the Time-Series Regression Forecasts? 265

9.1 Introduction, 265

9.2 Panel Data Exchange Rate Determination Studies, 267

9.3 Asymptotic Consequences of Pooling, 268

9.3.1 Predictive Regression Estimated on Full Sample, 268

9.3.2 Out-of-Sample Prediction, 271

9.4 Monte Carlo Study, 272

9.5 An Illustration with Data, 275

9.6 Conclusions, 278

References, 279

10 Carry Trades and Risk 283

10.1 Introduction, 283

10.2 The Carry Trade: Basic Facts, 285

10.2.1 What is a Carry Trade? 285

10.2.2 Measuring the Returns to the Carry Trade, 286

10.3 Pricing the Returns to the Carry Trade, 290

10.4 Empirical Findings, 293

10.4.1 Traditional Risk Factors, 293

10.4.2 Factors Derived from Currency Returns, 299

10.5 Time-Varying Risk and Rare Events, 308

10.6 Conclusion, 311

Acknowledgments, 311

References, 311

11 Currency Fair Value Models 313

11.1 Introduction, 313

11.2 Models/Taxonomy, 315

11.2.1 ‘‘Adjusted PPP’’: Harrod-Balassa-Samuelson and Penn Effects, 315

11.2.2 The Behavioral Equilibrium Exchange Rate Family of Models, 316

11.2.3 The Underlying Balance (UB) Approach, 320

11.2.4 External Sustainability (ES) Approach, 324

11.2.5 The Natural Real Exchange Rate (NATREX), 325

11.2.6 The Indirect Fair Value (IFV), 325

11.3 Implementation Choices and Model Characteristics, 328

11.3.1 Horizon/Frequency, 329

11.3.2 Direct Econometric Estimation Versus ‘‘Methods of Calculation’’, 331

11.3.3 Treatment of External Imbalances , 332

11.3.4 Real Versus Nominal Exchange Rates, 333

11.3.5 Bilateral Versus Effective Exchange Rate, 333

11.3.6 Time Series Versus Cross Section or Panel, 336

11.3.7 Model Maintenance, 336

11.4 Conclusion, 337

Acknowledgments, 338

References, 339

12 Technical Analysis in the Foreign Exchange Market 343

12.1 Introduction, 343

12.2 The Practice of Technical Analysis, 345

12.2.1 The Philosophy of Technical Analysis, 345

12.2.2 Types of Technical Analysis, 346

12.3 Studies of Technical Analysis in the Foreign Exchange Market, 350

12.3.1 Why Study Technical Analysis? 350

12.3.2 Survey Evidence on the Practice of Technical Analysis, 350

12.3.3 Computing Signals and Returns, 351

12.3.4 Early Studies: Skepticism before the Tide Turns, 353

12.3.5 Pattern Recognition, Intraday Data, and Other Exchange Rates, 353

12.4 Explaining The Success of Technical Analysis, 355

12.4.1 Data Snooping, Publication Bias, and Data Mining, 355

12.4.2 Temporal Variation in Trading Rule Returns, 357

12.4.3 Do Technical Trading Returns Compensate Investors for Bearing Risk? 359

12.4.4 Does Foreign Exchange Intervention Create Trading Rule Profits? 361

12.4.5 Do Cognitive Biases Create Trading Rule Profits? 363

12.4.6 Do Markets Adapt to Arbitrage Away Trading Rule Profits? 365

12.5 The Future of Research on Technical Analysis, 366

12.6 Conclusion, 367

Acknowledgments, 368

References, 368

13 Modeling Exchange Rates with Incomplete Information 375

13.1 Introduction, 375

13.2 Basic Monetary Model, 376

13.3 Information Heterogeneity, 379

13.4 Model Uncertainty, 381

13.5 Infrequent Decision Making, 385

13.6 Conclusion, 388

Acknowledgments, 388

References, 389

14 Exchange Rates in a Stochastic Discount Factor Framework 391

14.1 Introduction, 391

14.2 Exchange Rates and Stochastic Discount Factors, 392

14.2.1 Stochastic Discount Factors, 392

14.2.2 Real Exchange Rates and Currency Risk Premia, 395

14.3 Empirical Evidence, 398

14.3.1 From UIP Regressions to Currency Portfolios, 398

14.3.2 Annual Currency Excess Returns and Aggregate Risk, 399

14.3.3 Monthly Currency Excess Returns, 403

14.3.4 Implications for Stochastic Discount Factors, 403

14.3.5 Predictability of Currency Excess Returns, 405

14.4 Models, 407

14.4.1 Habits, 407

14.4.2 Long-Run Risk, 411

14.4.3 Disaster Risk, 414

14.5 Conclusion, 417

References, 417

15 Volatility and Correlation Timing in Active Currency Management 421

15.1 Introduction, 421

15.2 Dynamic Models for Volatility and Correlation, 424

15.2.1 The Set of Multivariate Models, 425

15.2.2 The Set of Univariate Models for Volatility Timing, 427

15.2.3 Pairwise Model Comparisons, 427

15.2.4 Estimation and Forecasting, 427

15.3 The Economic Value of Volatility and Correlation Timing, 428

15.3.1 The Dynamic Strategy, 428

15.3.2 Dynamic Asset Allocation with CRRA Utility, 428

15.3.3 Performance Measures, 429

15.3.4 Transaction Costs, 430

15.4 Parameter Uncertainty in Bayesian Asset Allocation, 430

15.5 Model Uncertainty, 431

15.5.1 The BMA Strategy, 432

15.5.2 The BMW Strategy, 432

15.6 Empirical Results, 432

15.6.1 Data and Descriptive Statistics, 432

15.6.2 Bayesian Estimation, 433

15.6.3 Evaluating Volatility and Correlation Timing, 434

15.7 Conclusion, 440

Appendix A: Univariate Models for Volatility Timing, 442

Appendix B: Parameter Uncertainty and the Predictive Density, 443

Acknowledgments, 444

References, 444

part three FX Markets and Products

16 Active Currency Management Part I: Is There a Premium for Currency Investing (Beta) 453

16.1 Introduction, 453

16.2 Beta in the Foreign Exchange Markets, 455

16.2.1 Understanding the FX Carry Trade, 455

16.2.2 FX Carry as a Broader Strategy, 456

16.2.3 FX Trend-Based Strategies, 458

16.2.4 Value-Based Strategies Within FX, 460

16.2.5 USD Directional Trade, 461

16.2.6 Correlation between these FX Strategies and Other Forms of Beta, 462

16.2.7 Weighted Portfolio of FX Strategies, 463

16.3 Multiple Forms of FX Beta, 465

16.4 Carry FX Indices from Banks, 465

16.5 Trend-Following FX Indices from Banks, 467

16.6 Conclusion, 468

References, 469

17 Active Currency Management Part II: Is There Skill or Alpha in Currency Investing? 471

17.1 Introduction, 471

17.2 Alternative Currency Management Mandates, 473

17.2.1 Features of a Currency Mandate, 473

17.2.2 Structural and Operational Choices, 476

17.2.3 The Alpha Continuum and Implications of Active Currency Mandates, 477

17.3 Benchmarks for Currency Fund Management, 477

17.3.1 A Basic Factor Model for Currency Returns, 479

17.4 Empirical Evidence with the Barclay Currency Traders Index and Individual Fund Managers, 481

17.4.1 Empirical Evidence with the Barclay Currency Traders Index, 481

17.4.2 Individual Currency Manager Returns, 485

17.4.3 Alternative Information Ratio, 493

17.5 Empirical Evidence: Fund Managers on the DB FX Select Platform, 496

17.5.1 Grouping Managers into a Fund of Funds, 496

17.6 Conclusions and Investment Implications, 498

References, 499

18 Currency Hedging for International Bond and Equity Investors 503

18.1 Introduction, 503

18.2 Overview of Empirical Hedging Studies, 504

18.3 Return and Volatility Impact of Currency Hedging, 506

18.3.1 Theoretical Background, 506

18.3.2 Methodology, 508

18.3.3 Summary of Findings on the Return and Volatility Impact of Currency Hedging, 525

18.4 Hedge Instruments—Currency Forwards versus Options, 526

18.4.1 Why Do Hedge Cash Flows Matter? 526

18.4.2 Historical Performance of Hedging with Options, 527

18.4.3 Summary of Findings on Hedging with Options Versus Forwards, 532

18.5 Managing Tracking Error in Forward Hedges, 533

18.5.1 How Often to Rebalance? 533

18.5.2 Trigger-Based Versus Regular Rebalancing, 539

18.5.3 Summary of Findings on Hedge Rebalancing, 539

18.6 Conclusions, 541

References, 543

19 FX Reserve Management 545

19.1 FX Reserve Management, 545

19.2 FX Reserve Uses, 545

19.3 FX Reserve Sources, 546

19.4 Objectives of Reserves Management, 547

19.5 Techniques of Reserve Management, 547

19.6 Historical Perspective, 548

19.7 What Assets Do Central Banks Hold? 549

19.8 Constraints, 550

19.9 External Managers, 551

19.10 Costs of Accumulation and Holding of Reserves, 551

19.11 Diversification, 552

19.12 Challenges to Diversification and Size of Reserves, 552

19.13 Changing Role of the Dollar as the International Reserve Currency, 554

19.14 Reserve Management if the Dollar is Replaced as the Reserve Currency, 557

19.15 Conclusion, 559

Acknowledgments, 559

References, 559

20 High Frequency Finance: Using Scaling Laws to Build Trading Models 563

20.1 Introduction, 563

20.2 The Intrinsic Time Framework, 565

20.3 Scaling Laws, 567

20.3.1 The New Scaling Laws, 568

20.3.2 The Coastline, 573

20.4 The Scale of Market Quakes, 574

20.5 Trading Models, 577

20.5.1 Overview, 577

20.5.2 Coastline Trader, 578

20.5.3 Monthly Statistics, 580

20.6 Conclusion, 582

Acknowledgments, 582

References, 582

21 Algorithmic Execution in Foreign Exchange 585

21.1 Introduction, 585

21.1.1 Drawing from the Equity Market, 586

21.1.2 What is Going to Work for Foreign Exchange? 587

21.2 Key Components of an Algorithmic Execution Framework, 589

21.2.1 Smart Order Routing (SOR), 589

21.2.2 Intelligence, 590

21.2.3 Speed, 591

21.3 Types of Algorithms, 592

21.3.1 Time Slicers, 592

21.3.2 Sweeper, 592

21.3.3 Iceberg, 592

21.3.4 Opportunistic, 592

21.3.5 Participators, 594

21.3.6 Internalization Strategies, 594

21.3.7 Dynamic Algorithms, 595

21.4 What Execution Strategies are Most Effective? 595

21.4.1 Measuring Performance, 596

21.5 Looking Forward, 596

Appendix A, 596

References, 597

22 Foreign Exchange Strategy Based Products 599

22.1 Introduction, 599

22.2 Evolution of the Foreign Exchange Market, 600

22.2.1 Disappointing Early Years, 600

22.2.2 Emergence of ‘‘Puzzles’’ in FX, 601

22.2.3 Growth of FX Market Turnover and Currency Managers, 602

22.3 Foreign Exchange Investable Indices and Strategy-Based Products, 606

22.3.1 Why Profit Opportunities Exist? 606

22.3.2 Beta and Alpha in Foreign Exchange, 607

22.3.3 Why is FX Attractive? 613

22.3.4 Why use Strategy-Based FX Products? 619

22.4 Conclusion, 620

References, 620

23 Foreign Exchange Futures, Forwards, and Swaps 623

23.1 Introduction, 623

23.2 Market Basics and Size, 625

23.2.1 FX Outright Forwards and Futures, 625

23.2.2 FX Swaps and Cross-Currency Swaps, 628

23.2.3 Market Size, 635

23.3 Dislocations of the FX and Cross-Currency Swap Markets under Financial Crises, 637

23.3.1 Japan Premium Case in the Late 1990s, 637

23.3.2 The Global Financial Crisis from 2007, 639

23.4 Conclusion, 643

Acknowledgments, 643

References, 643

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

Perspective 647

24.1 Introduction, 647

24.2 Why Would One Bother with an Option? 648

24.2.1 History, 648

24.2.2 FX Options, 649

24.3 Market for FX Options, 655

24.3.1 Overview, 655

24.3.2 Players, 656

24.3.3 Setting the Price, 658

24.4 Volatility, 660

24.4.1 Overview of Models, 660

24.4.2 Some Stylized Facts and Implied Moments, 664

24.4.3 Is Volatility an Asset Class? 666

24.4.4 Anti-Black Swan Strategies, 674

24.4.5 Black Swan Strategies, 676

24.5 FX Options from the Buy-Side Perspective, 683

24.5.1 Strike versus Leverage, 683

24.5.2 Implied Distribution, 685

24.5.3 Long-Dated Options versus Short-Dated Option, 689

24.5.4 Black Swan Fund, 692

24.5.5 Currency Hedging of Illiquid Assets, 693

Acknowledgment, 695

References, 695

part four FX Markets and Policy

25 A Common Framework for Thinking about Currency Crises 699

25.1 Introduction, 699

25.2 The KFG Model, 701

25.3 Extensions, 706

25.3.1 Attack-Conditional Monetary Policy, 706

25.3.2 Devaluation, 707

25.3.3 Sterilization and Interest Rate Defense, 709

25.3.4 Lender of Last Resort and Currency Crises, 711

25.4 Empirical Work, 713

25.5 Conclusion, 714

References, 715

26 Official Intervention in the Foreign Exchange Market 717

26.1 Introduction, 717

26.2 Official FX Interventions and Reserve Accumulation: Stylized Facts, Motives, and Effects, 721

26.3 Empirical Evidence on the Effectiveness of Official FX Interventions, 725

26.3.1 A Simple Conceptual Framework, 726

26.3.2 Time-Series Approach: Evidence on Effectiveness and Channels, 728

26.3.3 Event-Study Approach: Evidence on Longer-Term Effectiveness, 739

26.4 Conclusions, 746

26.5 Acknowledgements, 746

References, 747

27 Exchange Rate Misalignment—The Case of the Chinese Renminbi 751

27.1 Introduction, 751

27.2 Background, 752

27.3 Undervalued or Overvalued, 754

27.3.1 The FEER Misalignment Estimate, 754

27.3.2 The Penn Effect Regression, 757

27.3.3 Data Revision, 759

27.4 Concluding Remarks, 762

Acknowledgments, 763

References, 763

28 Choosing an Exchange Rate Regime 767

28.1 Five Advantages of Fixed Exchange Rates , 768

28.2 Econometric Evidence on the Bilateral Trade Effects of Currency Regimes, 770

28.2.1 Time-Series Dimension, 771

28.2.2 Omitted Variables, 772

28.2.3 Endogeneity of the Currency Decision, 773

28.2.4 Implausible Magnitude of the Estimate, 774

28.2.5 Country Size, 775

28.3 Five Advantages of Floating Exchange Rates, 775

28.4 How to Weigh Up the Advantages of Fixing Versus Floating, 777

28.5 Country Characteristics That Should Help Determine the Choice of Regime, 778

28.6 Alternative Nominal Anchors, 780

References, 781

Index 785