The objective of this paper is to provide the main guidelines to correctly handle the FX market conventions in order to build a consistent Volatility Smile. The models detailed for the Volatility Smile are: Vanna Volga, SABR and a Quadratic Polynomial in Delta. Hopefully, further research can incorporate these models instead of the one introduced by Malz. Also, it is shown how to estimate the Risk Neutral Density for the Vanna Volga and SABR models, which can be used for risk assessment or even to analyze monetary policy or interventions in the FX market.
{"title":"Volatility Smile and Risk Neutral Density for FX Options: An Example for the USDMXN","authors":"Luis Murra","doi":"10.2139/ssrn.2862185","DOIUrl":"https://doi.org/10.2139/ssrn.2862185","url":null,"abstract":"The objective of this paper is to provide the main guidelines to correctly handle the FX market conventions in order to build a consistent Volatility Smile. The models detailed for the Volatility Smile are: Vanna Volga, SABR and a Quadratic Polynomial in Delta. Hopefully, further research can incorporate these models instead of the one introduced by Malz. Also, it is shown how to estimate the Risk Neutral Density for the Vanna Volga and SABR models, which can be used for risk assessment or even to analyze monetary policy or interventions in the FX market.","PeriodicalId":413816,"journal":{"name":"Econometric Modeling: International Financial Markets - Foreign Exchange eJournal","volume":"171 1","pages":"0"},"PeriodicalIF":0.0,"publicationDate":"2016-12-19","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"116397218","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
We develop an incomplete markets framework to synthesize domestic and foreign stochastic discount factors (SDFs) that are consistent with limited international risk sharing. The funda- mental departure in our paper is that exchange rate growth need not equal the ratio of SDFs, and we develop a restriction that precludes “good deals” in international economies with in- complete markets. Our innovation is to study an incomplete markets problem that is consistent with SDFs that (i) are nonnegative, (ii) correctly price returns, and (iii) disallow “good deals.”
{"title":"Studying the Implications of Consumption and Asset Return Data for Stochastic Discount Factors in Incomplete International Economies","authors":"G. Bakshi, M. Cerrato, J. Crosby","doi":"10.2139/ssrn.2858834","DOIUrl":"https://doi.org/10.2139/ssrn.2858834","url":null,"abstract":"We develop an incomplete markets framework to synthesize domestic and foreign stochastic discount factors (SDFs) that are consistent with limited international risk sharing. The funda- mental departure in our paper is that exchange rate growth need not equal the ratio of SDFs, and we develop a restriction that precludes “good deals” in international economies with in- complete markets. Our innovation is to study an incomplete markets problem that is consistent with SDFs that (i) are nonnegative, (ii) correctly price returns, and (iii) disallow “good deals.”","PeriodicalId":413816,"journal":{"name":"Econometric Modeling: International Financial Markets - Foreign Exchange eJournal","volume":"1 1","pages":"0"},"PeriodicalIF":0.0,"publicationDate":"2016-10-25","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"131211826","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
In international economies with incomplete markets, the multiplicative wedge approach of Backus, Foresi, and Telmer (2001) encapsulates the idea that log exchange rate growth deviates from log relative of the stochastic discount factors by a perturbation. We analyze the asset pricing implications of this approach in the context of the trifecta of exchange rate puzzles, with three results. First, we analytically show that the currency risk premium is detached from the multiplicative wedge perturbation. This key result is both distribution-free and preference-free and implies that the approach cannot resolve the forward premium puzzle. Moreover, it is not feasible to reproduce the low unconditional volatility of exchange rate growth with realistic parameterizations. Finally, the slope coefficient in the Backus and Smith regression is not affected by the perturbation.
{"title":"The Multiplicative Wedge Approach to Incomplete Markets and the Trifecta of Exchange Rate Puzzles","authors":"G. Bakshi, J. Crosby","doi":"10.2139/ssrn.2837461","DOIUrl":"https://doi.org/10.2139/ssrn.2837461","url":null,"abstract":"In international economies with incomplete markets, the multiplicative wedge approach of Backus, Foresi, and Telmer (2001) encapsulates the idea that log exchange rate growth deviates from log relative of the stochastic discount factors by a perturbation. We analyze the asset pricing implications of this approach in the context of the trifecta of exchange rate puzzles, with three results. First, we analytically show that the currency risk premium is detached from the multiplicative wedge perturbation. This key result is both distribution-free and preference-free and implies that the approach cannot resolve the forward premium puzzle. Moreover, it is not feasible to reproduce the low unconditional volatility of exchange rate growth with realistic parameterizations. Finally, the slope coefficient in the Backus and Smith regression is not affected by the perturbation.","PeriodicalId":413816,"journal":{"name":"Econometric Modeling: International Financial Markets - Foreign Exchange eJournal","volume":"5 1","pages":"0"},"PeriodicalIF":0.0,"publicationDate":"2016-10-06","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"128947862","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
This paper investigates the relation between monetary conditions and the excess returns arising from an investment strategy that con- sists of borrowing low-interest rate currencies and investing in currencies with high interest rates, so-called "carry trade". The results indicate that carry trade average excess return, Sharpe ratio and 5% quantile differ substantially across expansive and restrictive conventional mone- tary policy before the onset of the recent financial crisis. By contrast, the considered parameters are not affected by unconventional monetary policy during the financial crisis. JEL Classification: F31, G15, E52
{"title":"Carry Trades and Monetary Conditions","authors":"A. Falconio","doi":"10.2139/ssrn.2854134","DOIUrl":"https://doi.org/10.2139/ssrn.2854134","url":null,"abstract":"This paper investigates the relation between monetary conditions and the excess returns arising from an investment strategy that con- sists of borrowing low-interest rate currencies and investing in currencies with high interest rates, so-called \"carry trade\". The results indicate that carry trade average excess return, Sharpe ratio and 5% quantile differ substantially across expansive and restrictive conventional mone- tary policy before the onset of the recent financial crisis. By contrast, the considered parameters are not affected by unconventional monetary policy during the financial crisis. JEL Classification: F31, G15, E52","PeriodicalId":413816,"journal":{"name":"Econometric Modeling: International Financial Markets - Foreign Exchange eJournal","volume":"7 1","pages":"0"},"PeriodicalIF":0.0,"publicationDate":"2016-10-04","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"130373537","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
This paper quantitatively compares the intrinsic features of the daily USD-GBP exchange rates in two different periods, the 1920s and the 2010s, under the same freely floating exchange rate system. Even though the foreign exchange markets in the 1920s seem to be much less organized and developed than in the 2010s, this paper finds that both the long memory volatility property and the structural break appear to be the common intrigue features of the exchange rates in the two periods by using the FIGARCH model. In particular, the long memory volatility properties in the two periods are found to be upward biased and overstated because of the structural breaks in the exchange markets. Thus this paper applies the Adaptive-FIGARCH model to consider the long memory volatility property and the structural breaks jointly. The main finding is that the structural breaks in the exchange markets affect the long memory volatility property significantly in the two periods but the degree of the long memory volatility property in the 1920s is reduced more remarkably than in the 2010s after the structural breaks are accounted for; thus implying that the structural breaks in the foreign exchange markets in the 1920s seem to be more significant.
{"title":"Quantitative Comparisons on the Intrinsic Features of Foreign Exchange Rates between the 1920s and the 2010s: Case of the USD-GDP Exchange Rate","authors":"Y. Han","doi":"10.2139/ssrn.2848840","DOIUrl":"https://doi.org/10.2139/ssrn.2848840","url":null,"abstract":"This paper quantitatively compares the intrinsic features of the daily USD-GBP exchange rates in two different periods, the 1920s and the 2010s, under the same freely floating exchange rate system. Even though the foreign exchange markets in the 1920s seem to be much less organized and developed than in the 2010s, this paper finds that both the long memory volatility property and the structural break appear to be the common intrigue features of the exchange rates in the two periods by using the FIGARCH model. In particular, the long memory volatility properties in the two periods are found to be upward biased and overstated because of the structural breaks in the exchange markets. Thus this paper applies the Adaptive-FIGARCH model to consider the long memory volatility property and the structural breaks jointly. The main finding is that the structural breaks in the exchange markets affect the long memory volatility property significantly in the two periods but the degree of the long memory volatility property in the 1920s is reduced more remarkably than in the 2010s after the structural breaks are accounted for; thus implying that the structural breaks in the foreign exchange markets in the 1920s seem to be more significant.","PeriodicalId":413816,"journal":{"name":"Econometric Modeling: International Financial Markets - Foreign Exchange eJournal","volume":"9 1","pages":"0"},"PeriodicalIF":0.0,"publicationDate":"2016-09-30","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"130018303","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
In this paper, we consider the valuation of European and path-dependent options in foreign exchange markets when the currency exchange rate evolves according to the Heston model combined with the Cox-Ingersoll-Ross (CIR) dynamics for the stochastic domestic and foreign short interest rates. The mixed Monte Carlo/partial differential equation method requires that we simulate only the paths of the squared volatility and the two interest rates, while an "inner" Black-Scholes-type expectation is evaluated by means of a partial differential equation. This can lead to a substantial variance reduction and complexity improvements under certain circumstances depending on the contract and the model parameters. In this work, we establish the uniform boundedness of moments of the exchange rate process and its approximation, and prove strong convergence of the latter in Lρ (ρ ⩾ 1). Then, we carry out a variance reduction analysis and obtain accurate approximations for quantities of interest. All theoretical contributions can be extended to multi-factor short rates in a straightforward manner. Finally, we illustrate the efficiency of the method for the four-factor Heston-CIR model through a detailed quantitative assessment.
{"title":"A Mixed Monte Carlo and Partial Differential Equation Variance Reduction Method for Foreign Exchange Options Under the Heston–Cox–Ingersoll–Ross Model","authors":"A. Cozma, C. Reisinger","doi":"10.21314/JCF.2016.318","DOIUrl":"https://doi.org/10.21314/JCF.2016.318","url":null,"abstract":"In this paper, we consider the valuation of European and path-dependent options in foreign exchange markets when the currency exchange rate evolves according to the Heston model combined with the Cox-Ingersoll-Ross (CIR) dynamics for the stochastic domestic and foreign short interest rates. The mixed Monte Carlo/partial differential equation method requires that we simulate only the paths of the squared volatility and the two interest rates, while an \"inner\" Black-Scholes-type expectation is evaluated by means of a partial differential equation. This can lead to a substantial variance reduction and complexity improvements under certain circumstances depending on the contract and the model parameters. In this work, we establish the uniform boundedness of moments of the exchange rate process and its approximation, and prove strong convergence of the latter in Lρ (ρ ⩾ 1). Then, we carry out a variance reduction analysis and obtain accurate approximations for quantities of interest. All theoretical contributions can be extended to multi-factor short rates in a straightforward manner. Finally, we illustrate the efficiency of the method for the four-factor Heston-CIR model through a detailed quantitative assessment.","PeriodicalId":413816,"journal":{"name":"Econometric Modeling: International Financial Markets - Foreign Exchange eJournal","volume":"6 1","pages":"0"},"PeriodicalIF":0.0,"publicationDate":"2016-08-10","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"128767523","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
Using foreign exchange transaction data reported in the Triennial Central Bank Survey by the Bank for International Settlements, we find that offshore renminbi (RMB) trading activity is affected by both the host economy's characteristics and links with China. For instance, the occurrence of offshore RMB trading is determined by the economy's GDP, stage of financial development, equity market capitalization and free trade agreement with China. When an economy hosts offshore RMB trading, the trading volume is affected by the size of its foreign exchange market, equity market capitalization, as well as the bilateral link with China through FDI flows.
{"title":"Offshore Renminbi Trading: Findings from the 2013 Triennial Central Bank Survey","authors":"M. Yiu, Y. Cheung","doi":"10.2139/ssrn.2819936","DOIUrl":"https://doi.org/10.2139/ssrn.2819936","url":null,"abstract":"Using foreign exchange transaction data reported in the Triennial Central Bank Survey by the Bank for International Settlements, we find that offshore renminbi (RMB) trading activity is affected by both the host economy's characteristics and links with China. For instance, the occurrence of offshore RMB trading is determined by the economy's GDP, stage of financial development, equity market capitalization and free trade agreement with China. When an economy hosts offshore RMB trading, the trading volume is affected by the size of its foreign exchange market, equity market capitalization, as well as the bilateral link with China through FDI flows.","PeriodicalId":413816,"journal":{"name":"Econometric Modeling: International Financial Markets - Foreign Exchange eJournal","volume":"1 1","pages":"0"},"PeriodicalIF":0.0,"publicationDate":"2016-08-08","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"115995555","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
We show how bad and good volatility propagate through forex markets, i.e., we provide evidence for asymmetric volatility connectedness on forex markets. Using high-frequency, intra-day data of the most actively traded currencies over 2007 - 2015 we document the dominating asymmetries in spillovers that are due to bad rather than good volatility. We also show that negative spillovers are chiefly tied to the dragging sovereign debt crisis in Europe while positive spillovers are correlated with the subprime crisis, different monetary policies among key world central banks, and developments on commodities markets. It seems that a combination of monetary and real-economy events is behind the net positive asymmetries in volatility spillovers, while fiscal factors are linked with net negative spillovers.
{"title":"Asymmetric Volatility Connectedness on Forex Markets","authors":"Jozef Baruník, E. Kočenda, Lukáš Vácha","doi":"10.2139/ssrn.2815151","DOIUrl":"https://doi.org/10.2139/ssrn.2815151","url":null,"abstract":"We show how bad and good volatility propagate through forex markets, i.e., we provide evidence for asymmetric volatility connectedness on forex markets. Using high-frequency, intra-day data of the most actively traded currencies over 2007 - 2015 we document the dominating asymmetries in spillovers that are due to bad rather than good volatility. We also show that negative spillovers are chiefly tied to the dragging sovereign debt crisis in Europe while positive spillovers are correlated with the subprime crisis, different monetary policies among key world central banks, and developments on commodities markets. It seems that a combination of monetary and real-economy events is behind the net positive asymmetries in volatility spillovers, while fiscal factors are linked with net negative spillovers.","PeriodicalId":413816,"journal":{"name":"Econometric Modeling: International Financial Markets - Foreign Exchange eJournal","volume":"42 1","pages":"0"},"PeriodicalIF":0.0,"publicationDate":"2016-07-27","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"123189142","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
The internationalization of China’s currency, the renminbi (RMB) bolsters the growing economic and political influence of China in the Asia-Pacific region. This paper assesses the evolution of RMB exchange rate co-movements against the US dollar (USD) within the region. While the RMB’s influence is growing, it is also found to be asymmetric and varying over time depending on the global movement of the USD. The trend is strong when the USD depreciates, but fades when the USD appreciates.
{"title":"Currency Comovements in Asia‐Pacific: The Regional Role of the Renminbi","authors":"D. Marconi","doi":"10.1111/1468-0106.12266","DOIUrl":"https://doi.org/10.1111/1468-0106.12266","url":null,"abstract":"The internationalization of China’s currency, the renminbi (RMB) bolsters the growing economic and political influence of China in the Asia-Pacific region. This paper assesses the evolution of RMB exchange rate co-movements against the US dollar (USD) within the region. While the RMB’s influence is growing, it is also found to be asymmetric and varying over time depending on the global movement of the USD. The trend is strong when the USD depreciates, but fades when the USD appreciates.","PeriodicalId":413816,"journal":{"name":"Econometric Modeling: International Financial Markets - Foreign Exchange eJournal","volume":"117 ","pages":"0"},"PeriodicalIF":0.0,"publicationDate":"2016-07-21","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"120876528","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
Research shows that the predictive ability of economic fundamentals for exchange rates is time-varying; it may be detected in some periods and disappear in others. This paper uses bootstrap-based methods to uncover the time-specific conditioning information for predicting exchange rates. Employing measures of predictive ability over time, statistical and economic evaluation criteria, we find that our approach based on pre-selecting and validating fundamentals across bootstrap replications leads to significant forecasts improvements and economic gains. The approach, known as bumping, robustly reveals parsimonious models with out-of-sample predictive power at 1-month horizon; and outperforms alternative methods, including Bayesian, bagging, and standard forecast combinations.
{"title":"Revealing Exchange Rate Fundamentals by Bootstrap","authors":"Pinho J. Ribeiro","doi":"10.2139/ssrn.2839259","DOIUrl":"https://doi.org/10.2139/ssrn.2839259","url":null,"abstract":"Research shows that the predictive ability of economic fundamentals for exchange rates is time-varying; it may be detected in some periods and disappear in others. This paper uses bootstrap-based methods to uncover the time-specific conditioning information for predicting exchange rates. Employing measures of predictive ability over time, statistical and economic evaluation criteria, we find that our approach based on pre-selecting and validating fundamentals across bootstrap replications leads to significant forecasts improvements and economic gains. The approach, known as bumping, robustly reveals parsimonious models with out-of-sample predictive power at 1-month horizon; and outperforms alternative methods, including Bayesian, bagging, and standard forecast combinations.","PeriodicalId":413816,"journal":{"name":"Econometric Modeling: International Financial Markets - Foreign Exchange eJournal","volume":"95 1","pages":"0"},"PeriodicalIF":0.0,"publicationDate":"2016-06-16","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"134143496","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
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