CH 4.3

Outline
1. Description of Foreign Exchange Trading

2. The Dealers Perspective
3. The Customers Perspective
1. Importers / Exporters
2. International Investors
4. The Policy Makers Perspective
Prof. Reitz
FX markets - Theory and Empirics
4. The Policy Makers Perspective_____________________________________________________
4 The Policy Makers Perspective

4.1 The performance of FX markets
4.2 FX market indicators
4.3 FX market intervention
Prof. Reitz
4.2 FX market indicators______________________________________________________________
4.2 FX market indicators

4.2.1 Harmonized competitiveness indicators
4.2.2 Capital market indicators
4.2.3 FX futures open positions
Prof. Reitz
4.2.3 FX futures open positions_______________________________________________________
Starting point
In recent years news on foreign exchange markets
have been analyzed on the grounds of whether a
change of a fundamental increases or decreases
interest rates.
For example, Inflationary pressure in the US
appreciates the US dollar, because agents expect US
dollar interest rates to go up.
Of course, standard macro would expect a decrease of
the US dollar as inflation is bad news!
Clarida and Waldman (2007):
IS BAD NEWS ABOUT INFLATION GOOD NEWS
FOR THE EXCHANGE RATE?
Prof. Reitz
Starting point
The logic of this relationship is based on the empirical
failure of UIP, which implies that selling low-yielding
currencies in order to buy high-yielding currencies is
profitable Currency carry trades
If this is true there is some risk of destabilizing
speculation:
Handelsblatt (02.11.06) Wette gegen den Franken
Spekulanten bringen den Kurs der Schweizer Whrung
unter Druck
Policy makers are interested in the importance of
destabilizing speculation in FX markets
Prof. Reitz
Data availability
In general, there is very little data on carry trades
available
FX trading of banks is not exposed to government
disclosure regulation
Moreover, carry trade strategy may be implemented
using a large variety of instruments
Exception:
Exchange-traded futures on Chicago Mercantile
Exchange (CME)
Prof. Reitz
Data availability
Data is made available by the commodities futures
trading commission (CFTC) on a weekly basis
Commitments of Traders Report
Traders are categorized as
Commercial
Non-commercial (which means financial)
Financial are suggested to act as speculators

Long contracts mean:
Buy foreign currency against USD for delivery 3 month
ahead
Prof. Reitz
CFTC data
Profit from selling at time t+3:
g t +3 = st + 3 f t ,t +3
= st + 3 (st (it* it ) )
Buying means that traders expect
st + 3 st > (it it* )

An open short contract in a low yielding currency
implies that the trader expect the currency to
appreciate by less than the interest differential, or, even
*
better, to depreciate: st + 3 st < (it it )
Prof. Reitz
CFTC data
Due to this logic it is suggested that the market
speculates on a future depreciation of a currency if
number of short contracts > number of long contracts
Prof. Reitz
Commitments of traders report (www.cftc.gov)
Prof. Reitz
10
CFTC data
Due to this logic it is suggested that the market
speculates on a future depreciation of a currency if
number of short contracts > number of long contracts
or net long positions negative
Are exchange rates correlated with net long positions?
Prof. Reitz
11
0,88
20000
0,86
10000
0,84
0
-10000
CHF/US-$
0,82
-20000
0,8
-30000
0,78
-40000
0,76
-50000
-60000
0,72
-70000
0,7
-80000
Ja
n.
Fe 0 5
b.
M 05
rz
.
A p 05
r.
M 05
ai
.
J u 05
n
Au . 05
g.
Se 05
p.
O 05
kt
.
No 0 5
v
De . 0 5
z.
Ja 05
n.
Fe 0 6
b.
A p 06
r.
M 06
ai
.
J u 06
n.
Ju 06
l.
A u 06
g.
Se 06
p.
O 06
kt
.0
6
0,74
Netto-Longkontrakte
CHF/USD exchange rate and net long pos. in CHF
Red line: Exchange rate ; blue line: net long positions

Prof. Reitz
12
CFTC data
Correlation coefficient quite large
Are exchange rates cointegrated with net long
positions?
Prof. Reitz
13
Cointegration relationship?
Euro
Kontraktvolumen
Yen
Pfund
Schweizer
Franken
125.000
12.500.000
62.500
125.000
Max. Eigen Statistik
29.15
31.77
27.11
46.04
Trace Statistik
30.40
37.13
27.58
46.48
0,59
131,21
1.57
0.38
0,30
(2.92)***
0,34
(6.28)***
0,15
(5.33)***
0,23
(6.34)***
0,41
(6.78)***
Lags (AIC, SIC)
Konstante
Trend
Netto-Longkontrakte
Prof. Reitz
14
Error correction model?
Prof. Reitz
15
Conclusions
Correlation between exchange rates and CME net long
positions quite large
Confirmed by cointegration relationship
Error correction model shows, however, that net long
positions do adjust, not exchange rates!
It seems that net open position do not granger cause
exchange rates
Note, however, that
Prof. Reitz
This is based on weekly data

CME covers only a very small fraction of FX market
16
4.3 FX market intervention_________________________________________________________
4.3 FX market intervention

4.3.1 Definition and technicalities
4.3.2 Reasons for intervention
4.3.3 Transmission channels
Lit.: Sarno und Taylor (2002), 208 244.
Definition
Official exchange rate intervention in the foreign
exchange market occurs when the authorities buy or
sell foreign exchange, normally against their own
currency and in order to affect the exchange rate.
Sarno/Taylor (2001), Official Intervention in the Foreign Exchange
Market: Is It Effective and, If So, How Does It Work?,
Journal of Economic Literature.
Types of intervention
Unilateral vs. coordinated intervention
Motives for coordination:
Strengthening of the policy signal
Increased credibility
Increased impact on exchange rates
Target vs. leaning against the wind-intervention

Depending on the reasons for intervention
(see following discussion)
Sterilised vs. non-sterilised intervention

Changing the monetary basis?

Buying and selling of forreign currency against domestic does change the
monetary basis in the first place (M). This may or may not be corrected!
M due to intervention
M remains
non-sterilised
M corrected
sterilised

Balance sheet transactions of the central bank
Assets
Liabilities
Net foreign Assets (NFA)

- Gold
Monetary Base
- Money in circulation
- Currency reserves
- Reserve holdings of banks
Net domestic assets (NDA)

- Government bonds
- Commercial bank bonds

Intervention in order to support the domestic currency
Example: ECB in 2000
Sell USD against Euro
Assets
Liabilities

- Gold
Monetary Base
- Currency reserves

- Government bonds

Offsetting measure: expansionary open market transaction
Assets
Liabilities

- Gold
Monetary Base
- Currency reserves

- Government bonds

Result:
Monetary basis unchanged
However: Changes in the structure of central banks assets
Assets
Liabilities

- Gold
Monetary Base
- Currency reserves

- Government bonds
4.3 Central bank intervention

4.3.1 Definition and technicalities
4.3.2 Reasons for intervention
Lit.: Sarno und Taylor (2002), 208 244.
4.3.2 Reasons for intervening in FX markets

Correcting misalignments
Target intervention
Plaza accord 1985
INTt = f S* St 1
Counter excess volatility
Leaning against the wind INTt = f (St 1 St 2 )

Louvre accord 1987
Support other central banks in their FX activity

Non-sterilised intervention alter the monetary basis and
works like standard monetary policy
B Ms P S (via KKP)
How do sterilized intervention change the exchange
rate?

Portfolio-Balance-Channel
Dominguez und Frankel (1993)
Signaling Channel
Mussa (1981)
Coordination channel
Reitz und Taylor (2008)
Portfolio Balance Channel

Assumptions:
Domestic and foreign assets are no perfect substitutes
Risk averse agents
Intervention alter the structure of outstanding assets

Changing risk premium influence exchange rates

Example:
Central bank sells reserves to support domestic currency
NFA and NDA in CB balance sheet (sterilisation)
Which means
NFA and NDA in private portfolios
Exchange rate risk , because the fraction of NFA in the
portfolio goes up!
Risk premium = (NFA/NDA)

Influence on the exchange rate:
UIP:
se = i ia + or
se + ia = i +
Means: Return on foreign assets must be higher than the

return on domestic assets
If then se (se = se s)
Given an exogenous long-run equilibrium value this is
possible only by a decrease of s!

Exchange rate goes down, because increased holdings
of NFA also increases the demanded risk premium
Problem:
The risk premium theory does not work empirically
Portfolio balance channel theoretically convincing, but
not empirically

Signalling Channel
Mussa (1981)
Reitz und Taylor (2008)
Signalling Channel
Foundation: Asset market approach of exchange rate
1
st =
1+

1 +
i =0
Et [ zt +i ]
Exchange rate as the sum of actual and future expected

discounted fundamentals
Expected changes of fundamentals like Ms alter todays
exchange rate
Intervention may signal a change in future monetary
policy!
Signalling Channel
Why is a simple announcement insufficient?
Mussa (1981):
.. monetary authorities follow a policy of putting their
money where their mouth is and stand ready to act on
the intervention signal.
Credibility problem enforce the central bank to put
money at stake
Central bank is betting on her own strategy change!
Signalling Channel
Empirical issue:
Have intervention been able to predict future policy
measures?
Empirical studies: Mixed evidence
(See survey in Sarno and Taylor 2002, pp. 226!)

Signalling Channel
Mussa (1981)
Reitz and Taylor (2008)
Prof. Reitz
38

CH 4.3

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Outline

1. Description of Foreign Exchange Trading

4. The Policy Makers Perspective

FX markets - Theory and Empirics

4. The Policy Makers Perspective_____________________________________________________

4 The Policy Makers Perspective

FX markets - Theory and Empirics

4.2 FX market indicators______________________________________________________________

4.2 FX market indicators

FX markets - Theory and Empirics

4.2.3 FX futures open positions_______________________________________________________

FX markets - Theory and Empirics

4.2.3 FX futures open positions_______________________________________________________

FX markets - Theory and Empirics

4.2.3 FX futures open positions_______________________________________________________

FX markets - Theory and Empirics

4.2.3 FX futures open positions_______________________________________________________

Financial are suggested to act as speculators

FX markets - Theory and Empirics

4.2.3 FX futures open positions_______________________________________________________

Buying means that traders expect

st + 3 st > (it it* )

FX markets - Theory and Empirics

4.2.3 FX futures open positions_______________________________________________________

FX markets - Theory and Empirics

4.2.3 FX futures open positions_______________________________________________________

Commitments of traders report (www.cftc.gov)

FX markets - Theory and Empirics

4.2.3 FX futures open positions_______________________________________________________

Are exchange rates correlated with net long positions?

FX markets - Theory and Empirics

4.2.3 FX futures open positions_______________________________________________________

CHF/USD exchange rate and net long pos. in CHF

Red line: Exchange rate ; blue line: net long positions

FX markets - Theory and Empirics

4.2.3 FX futures open positions_______________________________________________________

FX markets - Theory and Empirics

4.2.3 FX futures open positions_______________________________________________________

Max. Eigen Statistik

Lags (AIC, SIC)

FX markets - Theory and Empirics

4.2.3 FX futures open positions_______________________________________________________

Error correction model?

FX markets - Theory and Empirics

4.2.3 FX futures open positions_______________________________________________________

This is based on weekly data

FX markets - Theory and Empirics

4.3 FX market intervention_________________________________________________________

4.3 FX market intervention

Lit.: Sarno und Taylor (2002), 208 244.

4.3 FX market intervention_________________________________________________________

4.3 FX market intervention_________________________________________________________

Target vs. leaning against the wind-intervention

Sterilised vs. non-sterilised intervention

4.3 FX market intervention_________________________________________________________

Sterilised vs. non-sterilised intervention

4.3 FX market intervention_________________________________________________________

Sterilised vs. non-sterilised intervention

Net foreign Assets (NFA)

- Reserve holdings of banks

Net domestic assets (NDA)

4.3 FX market intervention_________________________________________________________

Sterilised vs. non-sterilised intervention