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Forward and Spot Exchange Rates in a Multi-Currency World

Last Updated on 10 February, 2024 by Rejaul Karim

InIn the groundbreaking research paper “Forward and Spot Exchange Rates in a Multi-Currency World” authored by Tarek A. Hassan and Rui C. Mano, a profound exploration into the violations of uncovered interest parity in a multi-currency context is unveiled.

By articulating a decomposition of these violations into three distinct components, including cross-currency, between-time-and-currency, and cross-time components, the study offers a transformative analytical framework to relate regression-based and portfolio-based anomalies and ascertain their empirical distinctiveness.

The revelations embedded in this study not only offer an understanding of the interconnected nature of anomalies but also enable the estimation of combined restrictions they impose on models of currency returns.

The intimate link between the forward premium puzzle (FPP) and the “dollar trade” anomaly, driven primarily by the cross-time component, alongside the distinct drivers of the “carry trade” anomaly, underscores the intricate dynamics at play in shaping currency returns in a multi-currency world, making a profound contribution to the domain of financial economics.

Abstract Of Paper

Separate literatures study violations of uncovered interest parity using regression-based and portfolio-based methods. We propose a decomposition of these violations into a cross-currency, a between-time-and-currency, and a cross-time component that allows us to analytically relate regression-based and portfolio-based anomalies, to test whether they are empirically distinct, and to estimate the joint restrictions they place on models of currency returns. We find that the forward premium puzzle (FPP) and the “dollar trade” anomaly are intimately linked. Both anomalies are almost exclusively driven by the cross-time component. By contrast, the “carry trade” anomaly is driven largely by the cross-currency component. The simplest model that the data do not reject features a highly persistent asymmetry that makes some currencies pay higher expected returns than others, and a more elastic expected return on the US dollar than on other currencies. In addition, we never reject the hypothesis that currencies with high interest rates are expected to depreciate rather than appreciate, so that none of our estimates require a systematic association between currency risk premia and predictable movements in exchange rates.

Original paper – Download PDF

Here you can download the PDF and original paper of Forward and Spot Exchange Rates in a Multi-Currency World.

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Author

Tarek A. Hassan
Boston University; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Rui C. Mano
International Monetary Fund

Conclusion

The profound insights delineated in “Forward and Spot Exchange Rates in a Multi-Currency World” by Tarek A. Hassan and Rui C. Mano shed light on the interconnected anomalies and distinct components that shape currency returns in the multi-currency landscape.

The intimate linkage between the forward premium puzzle (FPP) and the “dollar trade” anomaly, predominantly steered by the cross-time component, unveils the intricate interplay between anomalies in the multi-currency context.

Notably, the rigorous analysis underscores that the ‘carry trade’ anomaly is largely propelled by the cross-currency component, offering a transformative perspective that enriches our comprehension of the multifaceted dynamics governing currency returns.

The estimation of a model that features a persistent asymmetry in the expected returns on currencies and the elasticity of the expected return on the US dollar, coupled with the consistency in rejecting the hypothesis that high-interest rate currencies are expected to appreciate, amplifies our understanding of the complex interconnections shaping currency risk premia and predictable movements in exchange rates.

This innovative research not only sheds light on the intricate dynamics underlying currency returns amid varying anomalies but also offers an invaluable glimpse into the multifaceted mechanisms underpinning uncovered interest parity, making a substantive and transformative addition to the realm of financial economics.

Related Reading:

US Dollar Carry Trades in the Era of ‘Cheap Money’

Global Currency Hedging with Common Risk Factors

FAQ

Q1: What is the main contribution of the research paper “Forward and Spot Exchange Rates in a Multi-Currency World” by Tarek A. Hassan and Rui C. Mano?

A1: The main contribution of the research paper is the proposal of a decomposition of violations of uncovered interest parity (UIP) into three distinct components in a multi-currency context. These components include cross-currency, between-time-and-currency, and cross-time components. The paper provides an analytical framework to relate regression-based and portfolio-based anomalies and determines their empirical distinctiveness. It also enables the estimation of joint restrictions imposed by these anomalies on models of currency returns.

Q2: How does the paper link the forward premium puzzle (FPP) and the “dollar trade” anomaly?

A2: The paper finds an intimate link between the forward premium puzzle (FPP) and the “dollar trade” anomaly. Both anomalies are predominantly driven by the cross-time component. This linkage highlights the interconnected nature of these anomalies in a multi-currency world. The analysis suggests that understanding one anomaly, such as the FPP, contributes to understanding the “dollar trade” anomaly, and vice versa.

Q3: What component largely drives the “carry trade” anomaly, according to the findings?

A3: The findings indicate that the “carry trade” anomaly is largely driven by the cross-currency component. This component plays a significant role in shaping the “carry trade” anomaly in the multi-currency context. The identification of the distinct components contributing to different anomalies enriches our understanding of the dynamics of currency returns and the factors influencing them.

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