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Praise for Handbook of Exchange Rates “This book is remarkable. I expect it to become the anchor reference for people working in the foreign exchange field.” –Richard K. Lyons, Dean and Professor of Finance, Haas School of Business, University of California Berkeley “It is quite easily the most wide ranging treaty of expertise on the forex market I have ever come across. I will be keeping a copy close to my fingertips.” –Jim O’Neill, Chairman, Goldman Sachs Asset Management How should we evaluate the forecasting power of models? What are appropriate loss functions for major market participants? Is the exchange rate the only means of adjustment? Handbook of Exchange Rates answers these questions and many more, equipping readers with the relevant concepts and policies for working in today’s international economic climate. Featuring contributions written by leading specialists from the global financial arena, this handbook provides a collection of original ideas on foreign exchange (FX) rates in four succinct sections: * Overview introduces the history of the FX market and exchange rate regimes, discussing key instruments in the trading environment as well as macro and micro approaches to FX determination. * Exchange Rate Models and Methods focuses on forecasting exchange rates, featuring methodological contributions on the statistical methods for evaluating forecast performance, parity relationships, fair value models, and flow-based models. * FX Markets and Products outlines active currency management, currency hedging, hedge accounting; high frequency and algorithmic trading in FX; and FX strategy-based products. * FX Markets and Policy explores the current policies in place in global markets and presents a framework for analyzing financial crises. Throughout the book, topics are explored in-depth alongside their founding principles. Each chapter uses real-world examples from the financial industry and concludes with a summary that outlines key points and concepts. Handbook of Exchange Rates is an essential reference for fund managers and investors as well as practitioners and researchers working in finance, banking, business, and econometrics. The book also serves as a valuable supplement for courses on economics, business, and international finance at the upper-undergraduate and graduate levels. 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 1.3 Players and Information in FX Markets, 11 1.4 Electronic Trading Revolution in FX Markets, 21 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 2.3 Real Models of the Real Exchange Rate, 54 2.4 New Directions in Exchange-Rate Modeling, 60 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 3.3 Currency Trading Models and their Implications, 80 3.4 Exchange Rates, Order Flows, and the Macro Economy, 95 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 4.2 Exchange Rate Puzzles, 114 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 5.4 Trends in Currency Use, 141 5.5 Prospects for the Future, 144 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 6.4 Techniques of Testing PPP Theory in Economic-History Literature, 165 6.5 Price Variable in PPP Computations, 168 6.6 Modern Period: Testing of PPP, 169 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 6.9 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 7.4 Purchasing Power Parity, 200 7.5 Aggregating from the LOP to PPP: What Can We Infer? 205 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 8.3 Statistical Evaluation of Exchange Rate Predictability, 228 8.4 Economic Evaluation of Exchange Rate Predictability, 231 8.5 Combined Forecasts, 235 8.6 Empirical Results, 237 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 9.4 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 10.3 Pricing the Returns to the Carry Trade, 290 10.4 Empirical Findings, 293 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 11.3 Implementation Choices and Model Characteristics, 328 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 12.3 Studies of Technical Analysis in the Foreign Exchange Market, 350 12.4 Explaining The Success of Technical Analysis, 355 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 14.3 Empirical Evidence, 398 14.4 Models, 407 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 15.3 The Economic Value of Volatility and Correlation Timing, 428 15.4 Parameter Uncertainty in Bayesian Asset Allocation, 430 15.5 Model Uncertainty, 431 15.6 Empirical Results, 432 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 16.3 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 17.3 Benchmarks for Currency Fund Management, 477 17.4 Empirical Evidence with the Barclay Currency Traders Index and Individual Fund Managers, 481 17.5 Empirical Evidence: Fund Managers on the DB FX Select Platform, 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 18.4 Hedge Instruments–Currency Forwards versus Options, 526 18.5 Managing Tracking Error in Forward Hedges, 533 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 20.4 The Scale of Market Quakes, 574 20.5 Trading Models, 577 20.6 Conclusion, 582 Acknowledgments, 582 References, 582 21 Algorithmic Execution in Foreign Exchange 585 21.1 Introduction, 585 21.2 Key Components of an Algorithmic Execution Framework, 589 21.3 Types of Algorithms, 592 21.4 What Execution Strategies are Most Effective? 595 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 22.3 Foreign Exchange Investable Indices and Strategy-Based Products, 606 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 23.3 Dislocations of the FX and Cross-Currency Swap Markets under Financial Crises, 637 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 24.3 Market for FX Options, 655 24.4 Volatility, 660 24.5 FX Options from the Buy-Side Perspective, 683 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 25.4 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 26.4 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 27.4 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 28.3 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
