Understanding Exchange Rate Fluctuations: Macro Issues and Micro Data
Lead Research Organisation:
City, University of London
Department Name: Faculty of Finance
Abstract
Abstracts are not currently available in GtR for all funded research. This is normally because the abstract was not required at the time of proposal submission, but may be because it included sensitive information such as personal details.
Organisations
People |
ORCID iD |
| Lucio Sarno (Principal Investigator) |
Publications
Banti C
(2012)
Global liquidity risk in the foreign exchange market
in Journal of International Money and Finance
MENKHOFF L
(2012)
Carry Trades and Global Foreign Exchange Volatility
in The Journal of Finance
MENKHOFF L
(2016)
Information Flows in Foreign Exchange Markets: Dissecting Customer Currency Trades Information Flows in Foreign Exchange Markets
in The Journal of Finance
Menkhoff L
(2012)
Currency momentum strategies
in Journal of Financial Economics
Sarno L
(2012)
Properties of foreign exchange risk premiums
in Journal of Financial Economics
| Description | Main findings: (1) Currency order flow has substantial predictive ability for exchange rate returns. This result is obtained both in the context of standard cross-sectional portfolio sorts and in the context of a dynamic asset allocation strategy with endogenous transaction costs. (2) A large part of the information content of order flow can be explained ex post using a complex time-varying combination of "real-time'' macroeconomic data. However, standard combinations of macroeconomic forecasts fail to replicate ex ante the predictive ability of order flow as the latter strongly outperforms the former in terms of forecast power. This suggests that order flow provides an effective way of aggregating disperse macroeconomic information, as suggested by microstructure exchange rate models. (3) At the micro level, there is substantial heterogeneity across customer types: trading by corporate and private clients is generally not informative. Order flow by asset managers generates the strongest forecast power, and forecasts permanent exchange rate changes. Flows by hedge funds are also informative but only forecast transitory exchange rate movements. Furthermore, currency trading by hedge funds is significantly exposed to default, liquidity, and global volatility risk (Menkhoff, Sarno, Schmeling and Schrimpf, 2012). (4) We provide an empirical test of the scapegoat theory of exchange rates (Bacchetta and van Wincoop AER 2004, 2011). This theory suggests that market participants may at times attach more weight to individual economic fundamentals to rationalize the pricing of currencies, which are partly driven by unobservable shocks. We find empirical evidence that strongly supports the scapegoat theory, with the resulting models explaining a large fraction of the variation and directional changes in exchange rates (Fratzscher, Rime, Sarno and Zinna, 2015). 5) Using order flow data, the research proposes a measure of global liquidity risk in the FX market that may be seen as the analog of the well-known Pastor-Stambaugh liquidity measure for the US stock market. The analysis shows a strong common component in liquidity across currencies, and that liquidity risk is priced in the cross-section of currency returns, estimating the liquidity risk premium around 4.7 percent per annum (Banti, Phylaktis and Sarno, 2012). 6) The research documents the properties of the FX risk premium using a structural model that links exchange rates to the term structure of interest rates internationally (Sarno, Schneider and Wagner, 2012), and provides an in-depth analysis of the most popular currency trading strategies: "carry trades" that borrow in low interest rate currencies and invest in high interest rate currencies; and "momentum trades" that buy (sell) currencies that have done well (poorly) in the recent past (Menkhoff, Sarno, Schmeling and Schrimpf, 2012). |
| Exploitation Route | The research has generated further academic research by number of leading scholars in international macroeconomics and finance, as described in the impact report. At a practical level, the media coverage of several of the papers in media such as the FT or the WSJ indicate wide readership of the research findings among the practitioners community and among regulators. |
| Sectors | Financial Services, and Management Consultancy |
| Description | The project was about deepening our understanding of exchange rate fluctuations. First, for most economies in the world and their policy-makers, the evolution of the exchange rate is of critical importance as it affects a country's competitiveness in export markets, the value of asset and liabilities (often denominated in different currencies), the trade balance, central bank reserves, and the behaviour of domestic inflation via the impact of the exchange rate on import prices. In this sense, a better understanding of the future evolution of the exchange rate informs macro policy in a very direct fashion, and exchange rate analysis is an integral part of the forecasting efforts in most central banks and major policy institutions such as the IMF. Second, the evolution of the exchange rate is key to a number of companies, both financial and non-financial. Financial institutions trade currencies to serve the needs of their clients, and also trade on their own account. Asset managers (e.g. pension funds) have similar needs. Small and large commercial corporations that are exposed to currency risk are active in the FX market both for the purpose of carrying out transactions and for hedging against undesirable currency risk. In short, the goals of the project have both economic and societal impact by informing and providing input to the decision-making process of policy-makers and companies that need to form a view on currency fluctuations. The core practical findings of the research includes a set of lessons, or facts, that can be used by policy-makers and managers in all of their operations that are influenced by currency fluctuations, by improving their models to forecast exchange rates, to refine their understanding of the link between the evolution of exchange rates and the macroeconomy, to form better investment decisions when foreign currency-denominated assets are involved, and to better understand the functioning of the largest financial market in the world. Academic impact was also achieved by training of the next generation of researchers in this field. For example, one of the outputs listed (published in the Journal of International Money and Finance in 2012) is joint work with Chiara Banti, a former PhD student at Cass Business School who is now a Lecturer in Finance at the University of Essex since Autumn 2013. I have pursued a multi-channel approach in delivering impact: - Publications in top peer-reviewed academic journals in finance and economics, such as the Journal of Finance or the Journal of Financial Economics. - Dissemination of the research in working paper format on SSRN, CEPR, ECB and BIS working paper series, and directly by email to academic and practitioners as users of the research. - Presentations at conferences, workshops and seminar series around the world. - Liaising widely with the users community. For example, presentations on the research have been given upon invitation at Goldman Sachs Asset Management, Bloomberg and the Norwegian Sovereign Wealth Fund team. In the policy making arena, presentations have been given at the BIS, IMF, Bank of England, US Federal Reserve Bank of New York, among others. - In 2012 a conference was held at Cass Business School to present some of the findings of the research and debate progress in exchange rate research. The audience included about 80 delegates, with investors, policy makers and academics. - Cass Knowledge Online Portal- in house institutional repository aimed at business and the professions: https://www.cassknowledge.com/research/author/lucio-sarno The Cass Knowledge website receives 3,000 hits a week. - In addition, people read about some of the research in the business and financial press (including the FT, WSJ and other major media outlets). |
| First Year Of Impact | 2012 |
| Sector | Financial Services, and Management Consultancy |
| Impact Types | Societal,Economic |