Essays on Exchange Rates and Term Structures
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The overall theme of this dissertation is the explanation of the relationship between the exchange rates and the term structures of assets. Chapter 1, "Theoretical Exposition of Exchange Rate and Term Structures", develop a theoretical framework that links the term structures of assets to the exchange rate. After setting up the net present value (NPV) representation of the exchange rate in terms of stochastic discount factors (SDF) under no-arbitrage conditions, it describes how the current and expected future economic variables are incorporated into the exchange rate by referring to three major asset pricing approaches. Then, the term structures of two asset classes - sovereign credit default swap (CDS) and yield curves - are proposed to measure the market's expectations and perception of risk in driving the exchange rate dynamics. Chapter 2, "Currency returns, Credit Risk and its Proximity: Evidence from Sovereign Credit Default Swap", examines whether credit risk and its proximity are priced in currency returns by making use of information in the term structure of sovereign CDS. Building upon and modifying a CDS pricing model, I construct two risk measures explaining different aspects of risk perception: (i) "risk level", measured by the level of the CDS curve, represents whether the expected loss given credit events is high or low, and (ii) "risk proximity", measured by the slope of the CDS curve, captures how soon a specific credit event is likely to be materialized. Combined with the NPV representation of exchange rate, I set up a model where the exchange rate is determined by credit risk level and proximity. Using a broad data set between 2004 and 2017 for twenty countries, I show that risk level and proximity individually can explain a considerable amount of variation in currency returns and two risk measures together improve the predictive ability over a single CDS spread. Comparing the two, risk level broadly plays a stronger role during normal times, while risk proximity gains significance when financial crisis nears. These findings suggest that not only the credit risk level but also its proximity should be considered to assess the market's perception of risk driving currency movements. Chapter 3, "Global Financial Crisis and the Exchange Rate - Yield Curve Connection" co-authored with Yu-chin Chen and Kwok Ping Tsang, examines how the recent crisis and associated policy responses affect the relationship between market expectations, risk, and macro-fundamentals in driving exchange rate dynamics. To construct measures for expected macroeconomic conditions and perceived risk over future horizons, we decompose information in the term structure of interest rates across countries using several well-established yield-curve models. Data for eight major country pairs from 1995 to 2016 shows strong evidence that both expectations and risk premiums can explain subsequent exchange rate changes, with signs broadly consistent with theoretical predictions. We also observe clear structural changes, likely induced by unconventional monetary policy and the market’s changing risk attitude since 2008. Specifically, while expectations play a consistent role over the full sample period, risk premiums pick up their significance mostly after the crisis. Taylor-rule macro-fundamentals at first provide little-to-no marginal explanatory power for currency movements over the yield-curve components, but do become important during the zero-lower-bound period. These findings suggest a joint macro-finance approach to modeling yield curve, macro fundamentals, and exchange rates, to better encapsulate changing market conditions and policy responses.
- Economics