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Exchange Rates Essay

Essays on Exchange Rates and Emerging Markets

Ezequiel Aguirre

Essays on Exchange Rates and Emerging Markets
Aguirre, Ezequiel
Thesis Advisor(s):
Clarida, Richard H.
Ph.D., Columbia University
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This dissertation consists of three essays on exchange rates and international finance with an emphasis on emerging economies. In Chapter 1, I provide empirical evidence that supports the hypothesis that exchange rate based stabilization programs are expansionary during their early phases. I derive a new set of stabilization episodes using extensive country chronologies from Reinhart and Rogoff (2004) and I find that even after controlling for external conditions, the initial expansion associated with the introduction of an exchange rate based program, is caused by both, the program itself and positive external conditions. These expansionary effects are robust to different estimation methods and different criteria for detecting stabilization episodes. In Chapter 2, I study the relationship between foreign interest rates, country spreads, terms of trade and macro fundamentals in emerging markets. I estimate a structural VAR for 15 emerging economies. I find that country spreads explain 12% of output fluctuations, foreign interest rates an additional 7% and the terms of trade about 5%. I also find that country spreads account for a quarter of real exchange rate variability while the terms of trade account for just 1%. To further validate these results, I develop a dynamic stochastic general equilibrium (DSGE) model for a small open economy. The model incorporates several open economy frictions: i) bond-holding adjustment costs, ii) investment adjustment costs, iii) a working capital constraint, and iv) a country spread component that depends upon macro fundamentals, which is taken from the estimated VAR. The model is able to replicate fairly good the propagation effects of foreign rates and country spread shocks but overestimates the importance of the terms of trades. In Chapter 3, I investigate the relation between volatility in the foreign exchange market and excess returns on carry trade portfolios for the G10 currencies. I develop and compare three different investment strategies that aim at avoiding losses when volatility jumps, a common feature of the carry trade. I find that two trading strategies, one based on implied volatility from FX options and the other on exponentially-weighted moving averages, provide better risk-adjusted returns than the standard carry trade. A third strategy, based on Markov-switching exchange rate forecasts, provides excess returns for some currencies but fails for portfolios of currencies. I also show that currency investing provides superior Sharpe ratios than a benchmark bond portfolio and a benchmark stock portfolio, even after including the recent global financial crisis.
Foreign exchange rates
International finance
Foreign exchange
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Suggested Citation:
Ezequiel Aguirre, 2011, Essays on Exchange Rates and Emerging Markets, Columbia University Academic Commons, https://doi.org/10.7916/D8CV4QP7.


In response to the 2007 financial crisis and recession, the Federal Reserve System (the Fed) implemented conventional monetary policy by lowering the Federal funds rate in order to stimulate the economy. However, the Federal funds rate reached its zero-lower bound in November 2008, which meant that lowering the Federal funds rate was no longer an option, because it could not be lowered any further. As a result, the Fed began to implement unconventional monetary policy, by making large-scale asset purchases (LSAPs) usually referred to as quantitative easing (QE). This dissertation studies how monetary policy in the context of the move to unconventional monetary policy affects the behavior of the U.S. dollar vis a vis a number of important currencies. Three different perspectives concerning this policy move are offered.

The first essay examines how exchange rates are impacted by conventional and unconventional monetary policy using daily data. In addition, I test if there is any change in the volatility of exchange rates in the long run overall, pre and post November 2008. I employ a generalized autoregressive conditional heteroskedastic (GARCH) model to estimate the volatility of five exchange rates, namely the Australian dollar, the Canadian dollar, the Euro, the British pound, and the Japanese yen against the US dollar. Results show that interest rate spreads have significant impacts on exchange rate returns under conventional monetary policy regime, while the spreads have no impacts under unconventional regime. With respect to the impact on volatility in the long run, overall there is no significant change pre and post November 2008 for four out of the five cases.

The second essay focuses on the impact of monetary policy on exchange rate volatility from a narrower perspective. The analysis zeros in on the immediate effects of policy announcements on the volatility of the US dollar in the conventional versus unconventional monetary policy period. The advantage of using intraday data is that it enables me to better isolate the response of exchange rate movements to monetary announcements and separate those from other possible shocks in the same day. Focusing on the 25 minutes around the announcements, I find that the monetary policy announcements significantly impact exchange rate volatility. Compared with the conventional regime period, the impacts under the unconventional regime are greater for some exchange rates while they remain the same for the others.

The third essay examines the impact of monetary policy on exchange rates from the perspective of an emerging economy, Mexico. High frequency (second-by-second) data are used in this paper. This essay focuses on the impact of monetary policy on the volatility of the Mexican peso/U.S. dollar exchange rate, and compares it with the results in the second essay. I incorporate Mexico’s monetary policy to examine how the exchange rate volatility responds to monetary policy originating from both the US and Mexico. Results show that the volatility responds more to U.S. monetary policy compared to Mexican monetary policy. Besides, the impacts of the U.S. announcements last for longer periods than the Mexican announcements.

Recommended Citation

Wei, Wan, "Three Essays on Monetary Policy and Exchange Rate Behavior" (2017). Dissertations. 3090.

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