Liquidity and Exchange Rates: Puzzling Evidence from the G-7 Countries
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Create account Login Subscribe. While some countries persistently borrow over time, others act like bankers to the world — lending year in and year out. This column argues that these imbalances matter for asset pricing in financial markets, and are key to understanding excess returns in currency markets. Currency markets are an important source of risk premia.
Understanding why some currencies offer high returns and whether these returns provide adequate compensation for any additional risk they carry is of critical importance to all international investors. But which currencies offer high returns? But the carry trade is akin to picking up pennies in front of a steamroller — unexpected exchange rate adjustments can quickly turn the slow accumulation of gains into losses. In fact, the carry trade is known to perform poorly in volatile markets and experience large return drawdowns Menkhoff et al.
This characteristic is consistent with the standard financial notion of risk, i. Indeed, Lustig et al. This 'global risk' is found to explain the average returns across currency portfolios, appearing to complete liquidity and exchange rate traditional view of the currency market; high returns are available on high interest rate currencies providing compensation for bearing carry trade risk.
But recent findings show this traditional currency market view of the risk-return trade-off is only part of liquidity and exchange rate bigger liquidity and exchange rate.
The current account broadly captures the amount countries borrow liquidity and exchange rate the rest of the world in a given period. The Chilean peso, for example, offered an interest rate over twice as large as that in Australia and yet experienced a depreciation less than half the size of the Australian dollar. A differentiating factor between Australia and these emerging market countries is the external account. The external account can be thought of as the accumulation of borrowings over time.
In contrast, while the emerging market countries were also debtors to the world, the positions were considerably smaller: In a new research paper Della Corte et al. Within this variation emerges a clear finding: But there is a further twist.
Countries do not always issue external debt in their own currency. Many countries are, in fact, liquidity and exchange rate to issue debt in foreign currencies. In emerging market space almost all countries issue the entirety of their external debt in US dollars, euros or Japanese yen. Eichengreen and Hausmannhas additional implications for risk. If a country issues debt in its home currency, then a depreciation of the currency is good from a valuation perspective — the debt is worth less and hence the liability is lower.
In contrast, if the debt is issued in US dollars, a depreciation of the local currency against the US dollar is bad — it increases the value of debt, worsening the external debt position. We find a wide spread in returns. A portfolio of countries with a combination of a large external debt position relative to the size of liquidity and exchange rate overall economywith the majority of debt issued in foreign currency, generated the highest average currency return over our year sample.
In this large sample of developed liquidity and exchange rate emerging market currencies we find this extreme portfolio generated a return of around 5. We find that the investment performance of the strategy is impressive. The Sharpe ratio a measure of the return relative to risk is found to be comparable even liquidity and exchange rate the currency carry trade. But perhaps the finding simply indicates the trade has a strong relationship with the currency carry trade.
We explore this possibility by testing if the returns to the currency carry trade and the global imbalance trade are the same. We find that while the two trades are related, a big difference remains — there is potentially significant economic information contained within the global imbalance trade not contained in the returns to the currency carry trade.
It also implies that currencies which correlate more with this risk factor are the ones more exposed to global imbalance risk and thus require a higher return premium. In empirical asset pricing tests, we show that this global imbalance risk factor does provide significant explanatory liquidity and exchange rate to describe average currency returns and hence contains economic content important to currency market investors, as well as to anyone whose foreign portfolio indirectly exposes them to currency market risk.
Importantly, the risk factor provides economic content beyond the economic content contained in the risk factors previously documented by Lustig et al. But this finding raises a question: Recent theoretical developments in currency markets provide the answer and complete this risk-based story.
Gabaix and Maggiori develop a modern portfolio-balance theory in which a financial intermediary holds liquidity and exchange rate. Risk arises from the intermediary having a mismatch in the currencies in their portfolio. In volatile periods — such as following the collapse of Lehman Brothers — this risk-bearing capacity falls dramatically and holding a large quantity of any currency becomes particularly burdensome.
But which currencies is the intermediary likely to hold on their balance sheet? It turns out that debtor currencies feature prominently.
Households in the debtor country borrow in foreign currency to buy goods liquidity and exchange rate services from firms in the creditor country. To compensate, the intermediary expects a positive currency return on any currency mismatch. The theory also provides additional important implications. Over time, when risk-bearing capacity falls, debtor currencies should depreciate by the most because the intermediary will instantly require liquidity and exchange rate larger expected return to hold these currencies.
We test this implication in the data and document strong empirical support for the prediction. When foreign exchange volatility rises, debtor currencies depreciate by significantly more than creditor currencies. Interestingly, this finding continues to hold even when controlling for interest liquidity and exchange rate. In fact, when volatility rises, the interest liquidity and exchange rate is significantly less important than the external account of the country for determining the impact on exchange rate fluctuations.
Global imbalances are not a new topic, and indeed economists have discussed their sustainability for years e. But the link to financial markets and asset prices has been relatively unexplored. While reference is frequently made to this possible link in the financial press, we document liquidity and exchange rate evidence linking currency returns to the global imbalance phenomenon.
The key finding is that debtor countries issue riskier currencies — a risk that is amplified if the debt is issued in foreign currency.
The finding also has strong theoretical foundations; financial intermediaries require a premium to compensate them for bearing currency mismatches on their balance sheet, a mismatch that is largely driven by debtor currencies in an imbalanced financial world. Exchange rates Financial markets. The narrowing of global imbalances. Volatility insurance and exchange rate predictability. Did global imbalances cause the crisis?
The link between currencies and global imbalances In a new research paper Della Corte et al. A new source of currency market risk? Why liquidity and exchange rate debtor countries risky? Conclusions Global imbalances are not a new topic, and indeed economists have discussed their sustainability for years e.
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