The trouble with (sterilized) FX interventions in emerging markets

April 5, 2014

Large foreign exchange interventions are common in emerging markets, typically in response to capital flows. What is less well understood is the expansionary (contractionary) impact of FX purchases (sales) on local credit, even if the transactions are sterilized. Sterilization securities mostly end up on banks’ balance sheets, where they function as substitutes for bank reserves, serve as collateral, and encourage banks to expand their loans-to-securities ratios.

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An overview of financial crisis theories

March 29, 2014

Daniel Detzer and Hansjoerg Herr deliver a superb summary of timeless economic theories of financial crisis. The main focus is on (i) escalatory inflation and deflation dynamics caused by monetary policy, (ii) boom and bust investment cycles caused by herding and inefficient expectation formation, and (iii) speculative bubbles related to cognitive behaviour that is inconsistent with efficient markets.

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Financialization of commodity markets: the basics

March 22, 2014

An academic summary paper shows how the structure of commodity markets has changed, most notably through the growth of commodity index investors. This has raised the correlation of commodities with other asset classes. Moreover, this financialization may impair at times the two key functions of commodity markets: risk sharing and price discovery.

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High-speed trading: lessons from quantum physics

February 14, 2014

Modern physics teaches that objects behave differently as they reach the speed of light. This has become relevant for financial market execution. While prices pretend to be global, in reality they depend on location. Liquidity at any given price is uncertain. And physical location becomes critical for the success of certain trading styles. Moreover, quantum physics suggest that ‘freak events’ that destabilize the markets are likely to occur.

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Herding in financial markets

February 1, 2014

Herding is a deliberate decision to imitate the actions of others. In financial markets with private information herding can be efficient for an individual asset manager, but increases the risks that the market as a whole is inefficient and fragile, particularly in the case of “information cascades”. A paper of Michael McAleer and Kim Randalj provides empirical evidence of herding in a range of futures markets.

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Volatility insurance and exchange rate predictability

January 26, 2014

The cost of insuring against currency volatility can be measured as the difference between (options-based) implied volatility and (swaps-based) forward expected realized volatility. A case can be made that this insurance premium determines how much exposure risk-averse institutions are willing to accept. A new paper and blog post by Della Corte, Ramadorai, and Sarno claim that variations in volatility insurance costs can be the basis for a profitable currency trading strategy.

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The concept of “real financial exchange rates”

January 11, 2014

A Bundesbank paper proposes a new type of real exchange rate index. Rather than measuring the competitiveness of goods markets, this “real financial exchange rate” would measure the competitiveness of asset markets. There is some evidence that this indicator helps detecting overvaluation.

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How fear of disaster affects financial markets

December 14, 2013

Fear of economic disasters, such as depressions, is more frequent than their actual occurrence. People tend to perceive a growing risk of disaster as they see economic conditions deteriorate. A new Federal Reserve paper illustrates that this pro-cyclicality of fears can trigger fluctuations in equity prices that go well beyond the actual changes in economic conditions, consistent with actual historical experience. Disaster fears also can make asset returns partly predictable.

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Commodity exchange prices: The curious case of aluminum

November 13, 2013

Goldman Sachs Research takes another look at soaring warehouse queues and fears of price distortions in the aluminum market (see previous post here). A case can be made that inventories have risen as consequence of a supply surplus, rather than distortions. The price of physical metal, traded outside the exchange, appears to evolve in line with fundamentals. By contrast, the exchange price trades at a discount, because it only entitles to a warrant for cheapest delivery and not to physical metal at the required location. The variation of this discount constitutes basis risk for producers or consumers that use it for hedging, compromising the validity of the London Metals Exchange prices.

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Current accounts and foreign exchange returns

November 6, 2013

A research report by Jens Nordvig and his colleagues at Nomura shows that external (current account) surpluses have been a poor indicator of currency performance over the past 20 years. External deficits are often the consequence of growth outperformance, decreasing country risk premiums and capital inflows, and hence may be associated with currency strength rather than currency weakness.

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asset management Asset Purchase Program banks bond returns bond yields bubbles capital regulation carry China collateral commodities credit returns default ECB economic data EM equity returns euro area crisis Fed financial crisis FX FX interventions FX returns government debt government deficits herding inflation information insurances Japan leverage liquidity machine learning market turmoil price factors regulation risk management shadow banking statistical methods term structure trend following variance risk premium VIX volatility ZLB
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