Wednesday, April 23, 2014
Sunday, April 20, 2014
The active nature of the currency markets (with a day-to-day turnover of over USD 5 trillion), coupled with high market concentration and the individual’s ability to operate with extremely high take advantage of ratios, means that even small rate motions in this market can translate into economically significant impacts. For example, according to the Bank of International Settlements, USD 364 billion are traded daily in the AUD-USD market (compared with USD 30 trillion traded on the NYSE). For that reason, as a back of the envelope estimation, a 2 percent appreciation of the Australian Dollar against the U.S. dollar leads to a USD 7.28 billion move which, given the high take advantage of ratios, a 1 percent margin is typical, suggests a USD 728 billion movement in financier’s balance sheets.
In this paper, we document that statements by the FOMC have a financially and statistically substantial impact on the excess returns of a host of different currencies vis-a-vis the U.S. dollar. More particularly, by relying on high-frequency data, we record that a trading strategy that is brief the U.S. dollar and long other currencies exhibits considerably bigger excess returns on days with set up FOMC statements relative to non-announcement days. Crucially, the excess returns made by following such a strategy cover the whole statement day, including a pre- as well as a post-announcement element. We also record that these excess returns (i) are greater for currencies with greater rate of interest differentials vis-a-vis the United States; (ii) increase with market participant’s unpredictability about monetary policy; and (iii) magnify when the Fed adopts a policy of monetary alleviating.
We analyze these findings through the lens of a parsimonious model of exchange rate decision, in which constrained financiers with brief investment horizons intermediate international need for currencies. Higher currency returns during announcement days are suggested to compensate financiers for the uncertainty in financial policy, hence, even if the Federal Reserve does not take any action or leaves the target federal funds rate as is, investors will earn a premium for holding the currency during these risky days. We know that an ex post adoption of an expansionary financial policy (corresponding to an interest rate decrease by the Fed) additional increases currency returns.
To empirically study currency danger premia around statement days, we use 20 years of high-frequency information for the 10 most traded currencies. We document that returns earned on the 8 statement day account for a substantial fraction of the currencies annual excess returns.
Our description for these large returns around announcement days is that they reflect a premium for heightened financial policy unpredictability or more usually a tightening of investors risk-bearing capacity. Using different proxies for monetary policy uncertainty (such as an indicated volatility index from Treasury futures choices and an uncertainty measure built from survey projections about the future federal funds rate), we discover that an increase in market participant’s unpredictability is indeed related to greater returns around FOMC announcement days.