Currency Mispricing and Dealer Balance Sheets

Gino Cenedese, Pasquale Della Corte and Tianyu Wang

Deviations from covered interest parity (CIP) represent an arbitrage opportunity, at least in theory. In a new paper, we show that post-crisis financial regulation may explain why this mispricing persists and cannot be arbitraged away. Our exercise uses a unique dataset on contract-level foreign exchange derivatives coupled with an exogenous variation associated with the public disclosure of the leverage ratio. We find that dealers with a higher leverage ratio demand an extra premium from their clients for synthetic dollar funding (e.g., borrowing in euros and swapping into dollars) relative to direct dollar funding (i.e., borrowing dollars in the money market), resulting in CIP deviations.

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Imports and the composition of expenditure

Alex Tuckett

A fall in the real exchange rate can increase demand for domestic output in two main ways. The volume of exports – which become cheaper – is boosted. And goods and services that were previously imported can instead be supplied by domestic producers, which become more competitive as the price of imports rises. Economists call the second effect ‘import substitution’. Using data from Supply-Use tables can help us better understand the process of import substitution, in particular by examining how the composition of expenditure has influenced imports. Doing so shows that the import substitution effect of the 2008-09 depreciation was partly masked by other, co-incident factors.

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Friedman was right: flexible exchange rates do help external rebalancing

Fernando Eguren-Martin.

Do exchange rate regimes matter for the formation of countries’ external imbalances? Economists have thought so for over sixty years, and policymakers have made countless recommendations based on that presumption. But this had not been tested empirically until very recently, so it remained an opinion rather than a fact. In this post I show that having a flexible exchange rate regime leads to the correction of external imbalances in developing countries, offering some empirical support to a widely held belief. In contrast, this does not seem to be the case for advanced economies.

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How important are interest rates for exchange rates?

Fernando Eguren-Martin and Karen Mayhew.

Many would say that when domestic interest rates rise (relative to abroad) the domestic currency will appreciate. But is it right to think like this? In this blog we use exchange rate theory to inform this discussion and to assess the importance of relative interest rates in accounting for past exchange rate moves. We find that relative interest rates typically move in the same direction as exchange rates but most of the time they account for a small share of exchange rate variation. However, academics might question our use of such a theory as its failure to forecast exchange rates is well documented. We show that this is somewhat unfair, as even if the framework is not very useful in terms of forecasting it is still a useful tool for decomposing past moves in exchange rates.

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The Relation Between Stock and Currency Returns

Gino Cenedese, Richard Payne, Lucio Sarno and Giorgio Valente.

Various theories suggest that exchange rate fluctuations and stock returns are linked. We find little evidence of a relation between the two. Thus, a simple trading strategy that invests in countries with the highest expected equity returns and shorts those with the lowest generates substantial risk-adjusted returns. This strategy is akin to a carry trade strategy executed using stocks rather than money market instruments, but is uncorrelated with the conventional carry trade strategy. The returns can only be partly explained as compensation for risk.

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