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Dislocations in the Won-Dollar Swap Markets During the Crisis of 2007-09
International Journal of Finance & Economics
Abstract
Foreign exchange (FX) derivatives markets in the Korean won are comparatively thin and vulnerable to impaired functioning. During the crisis, Korea faced dislocations in its FX swap and cross-currency swap markets, so severe that covered interest parity (CIP) between the Korean won and the US dollar was seriously violated. Using a variation of the EGARCH model, we find that global market uncertainty - as proxied by VIX, the volatility index - was the main factor explaining the movement of deviations from CIP in the three-month FX swap market during the crisis period. The credit risk of Korean banks - as proxied by their credit default swap spread - was also a significant factor explaining deviations from CIP in the three-year cross-currency swap market before the crisis, while the credit risk of US banks was significant during the crisis period. The Bank of Korea's provision of funds using its own foreign reserves was not effective in reducing deviations from CIP, but the Bank of Korea's loans of the US dollar proceeds of swaps with the US Federal Reserve were effective. This is because the loans funded by swaps with the US Federal Reserve effectively added to Korea's foreign reserves and enhanced market confidence.
... Baba and Packer (2009) demonstrated that a heightened funding liquidity risk and counterparty risk during the 2008 GFC led to a sharp increase in CID of the U.S. dollar-Euro currency pairs and their finding was confirmed by Coffey et al. (2009) and Griffoli and Ranaldo (2012) for other currency pairs as well. Baba and Shim (2014) showed that a regime-switching analysis of CID identified a crisis period starting in mid-2007, and the crisis momentum was the main factor responsible for the sharp deviation of CIP in Korea. ...
... Through improved market confidence, the Korean foreign exchange and banking system quickly regained stability. Furthermore, what has drawn policy makers' particular attention is that the US dollar loans of proceeds of swap with the Fed were effective, whereas the use of the BOK's own foreign reserves was not (Baba and Shim 2014). Casting a doubt about the efficacy of central bank's intervention using official reserves, several recent studies, having analyzed the policy effects on CIP deviations, stressed the key role of dollar swap lines established by the Fed, and other lenders of last resort, in ameliorating distortions in the FX swap market (e.g., Baba and Packer 2009;Coffey et al. 2009). ...
This study aims to test the efficiency of the Korean foreign exchange market and examine its determinants through several well-established methodologies based on the forward rate unbiasedness hypothesis and covered interest rate parity. The empirical findings indicate that the currency market and its related derivatives markets seem to be inefficient during the 2006–2016 period, but have improved considerably after the 2008 global financial crisis. Further, as the main culprits of market inefficiency, we stress the presence of risk premia in the international financial market and the role of central bank intervention.
... As the FX forward market was too small, it became too dependent on these operations and, as a result, they tended to push the exchange rate up. This, in turn, drove the forward discount rate above the interest rate diff erential between the US and Korea ( Baba and Shim, 2011 ), and, therefore, it led to higher expected returns on bonds (Lee, Kim and Song, 2010 ). ...
... Korean banks were now borrowing US dollars almost exclusively from foreign bank branches (Kim, 2009). Dependence on foreign banks, however, increased even further as domestic banks relied heavily on FX swap transactions (Lee, 2010 ;Baba and Shim, 2011 ). This near-monopoly status in supplying US dollars to the Korean market certainly refl ected their power after liberalization. ...
... During the crisis period, Korea experienced one of the most severe deviations in covered interest parity, as FX swap and cross-currency swap markets were not deep enough to handle the U.S. dollar funding pressures. Several studies focus on the structural demand-supply imbalance in the FX forward market due to massive selling of FX forwards by Korean shipbuilder, heavy industry companies and Korean investors in foreign stocks (Baba and Shim, 2011, Kim et al. 2009, Hwang, 2010 billion, suggesting that without an adequate FX supply response, deviations in CIP and a U.S. dollar premium will persist. ...
Asian countries have high demand for U.S. dollars and are sensitive to U.S. dollar funding costs. An important, but often overlooked, component of these costs is the basis spread in the cross-currency swap market that emerges when there are deviations from covered interest parity (CIP). CIP deviations mean that investors need to pay a premium to borrow U.S. dollars or other currencies on a hedged basis via cross-currency swap markets. These deviations can be explained by regulatory changes since the global financial crisis, which have limited arbitrage opportunities and country-specific factors that contribute to a mismatch in the demand and supply of U.S. dollars. We find that an increase in the basis spread tightens financial conditions in net debtor countries, while easing financial conditions in net creditor countries. The main reason is that net debtor countries are, in general, unable to substitute smoothly to other domestic funding channels. Policies that promote reliable alternative funding sources, such as long-term corporate bond market or stable long-term investors, including a “hedging counterpart of last resort,” can help stabilize financial intermediation when U.S. dollar funding markets come under stress.
... Due to the functioning mechanisms of the flexible dollar standard, and the transition of the monetary dollar to the financial dollar, the currency and derivatives markets are strongly connected. Baba and Packer (2009) and Baba and Shim (2011) suggest the financial crisis created turbulences and displacements on the currency swap market, an intrinsically fragile and volatile derivative markets, able to quickly transmit imbalances to traded assets on spot markets. The deepening of the economic crisis was avoided by cooperation between central banks, using swaps or transferences, with the United States Federal Reserve accepting payment flows in Euro and other currencies and other central banks receiving payments in dollars . ...
Access to the Complete Edition (n.1 | v.1 | Jan-Jun 2012)THE CRISIS TRANSFORMS THE INTERNATIONAL SYSTEM: EMERGING SOUTHERN CONNECTIONS
... Foreign investors 6 For a discussion of the discrepancies between CIP-implied funding currency interest rates and interest rates in advanced economy money and debt markets during the global financial crisis, see Baba and Packer (2009) and Baba, Packer and Nagano (2008). For an emerging market example (Korea), see Baba and Shim (2014). 7 The returns from such a strategy may be described by: ...
JEL Classification: F31, G15 The views expressed are those of the authors and not necessarily the views of the BIS. This publication is available on the BIS website (www.bis.org). © Bank for International Settlements 2015. All rights reserved. Brief excerpts may be reproduced or translated provided the source is stated. ISSN 1609-0381 (print) ISBN 978-92-9197-081-0 (print) ISSN 1682-7651 (online) ISBN 978-92-9197-080-3 (online)
... Due to the functioning mechanisms of the flexible dollar standard, and the transition of the monetary dollar to the financiai dollar, the currency and derivatives markets are strongly connected. Baba and Packer (2009) and Baba and Shim (2011) suggest the financiai crisis created turbulences and displacements on the currency swap market, an intrinsically fragile and volatile derivative markets, able to quickly transmit imbalances to traded assets on spot markets. The deepening of the economic crisis was avoided by cooperation between central banks, using swaps or transferences, with the U nited States Federal Reserve accepting payment flows in Euro and other currencies and other central banks receiving payments in dollars . ...
This paper discusses the US dollar hegemony in the world economy. The discussion is carried out in three steps. First, the paper analyses the evolution of the US dollar in the world economy, emphasizing its resilience in the context of frequent financial crises. Second, the work discusses and compares the perspectives that trust the US dollar's continuing role as an international reserve to those that assume a likely decline of both the dollar and the US economy after the 2007 financial crash. Finally, the article seeks to raise a few potential consequences of the continuing hegemony or declining of the dollar for the peripheral countries.
... 6 While CDs are included in deposits under the US banks' accounting system, they are separately accounted for by Korean banks. 7 Baba and Shim (2011) point out that Bank of Korea loans funded by the swap lines with the Federal Reserve were more effective than swaps using its own foreign reserves. This suggests that a country's own foreign reserves and inter-central bank swap arrangements are far from perfect substitutes. ...
South Korea is arguably the premier development success story of the last half century. For 47 years starting in 1963, the economy averaged 7 percent real growth annually, and experienced only two years of economic contraction: 1980 after the second oil shock and the assassination of President Park Chung-hee, and 1998 at the nadir of the Asian financial crisis. At the start of that period South Korea had a per capita income lower than that of Mozambique or Bolivia; today it is richer than Spain or New Zealand, and was the first Asian and first non-G7 country to host a summit of the G20, the unofficial steering committee of the world economy. The South Korean case is of interest for a variety of reasons. Rapid growth coincided with extensive state interventions in the economy, and considerable controversy exists as to how much this performance should be credited to the country’s state-led development strategy and to what extent the lessons from that experience might be portable or applied elsewhere. The salience of this issue has grown as South Korea has become a more important provider of development assistance and advice. Now the country faces challenges in maintaining its superior economic performance in the face of an aging population domestically and a taxing external environment. Finally, the country confronts scenarios involving potential instability, collapse, and/or absorption of its neighbor, North Korea.
La teoría del equilibrio de poderes parece más adecuada que la «Trampa de Tucídides» para interpretar la actual tensión entre China y Estados Unidos. Las críticas a su etnocentrismo parecen olvidar factores de oc- cidentalización todavía presentes en Asia Oriental, que condicionarían la emancipación china. Sin embargo, el equilibrio de poderes global no evitaría la conflictividad regional, por lo que deben también considerarse aquellos factores que podrían desencadenar una espiral de beligerancia. El escenario postpandémico podría iniciar una etapa iliberal de regloba- lización, donde el neoproteccionismo sería un arma de contención.
The balance of power theory seems more adequate than the "Thucydides Trap" to interpret the present tension between China and the United States. Criticisms of its ethnocentrism seem to forget Westernisation factors still present in East Asia that limit Chinese emancipation. Nevertheless, a global balance of power would not prevent regional conflict, so factors that could trigger a spiral of belligerence should also be considered. The post-pandemic scenario could initiate an illiberal stage of re-globalisa-tion, where neo-protectionism could be a weapon of containment.
Asian countries have high demand for US dollars and are sensitive to US dollar funding costs. An important, but often overlooked, component of these costs is the basis spread in the cross-currency swap market that emerges when there are deviations from covered interest parity (CIP). CIP deviations mean that investors need to pay a premium to borrow US dollars or other currencies on a hedged basis via the cross-currency swap markets. These deviations can be explained by regulatory changes since the GFC, which have limited arbitrage opportunities and country-specific factors that contribute to a mismatch in the demand and supply of US dollars. We find that an increase in the basis spread tightens financial conditions in net debtor countries, while eases financial conditions in net creditor countries. The main reason is that net debtor countries are, in general, unable to substitute smoothly to other domestic funding channels. Policies that promote reliable alternative funding sources, such as long-term corporate bond market, or stable long-term investors, including a “hedging counterpart of last resort,” can help stabilize financial intermediation when US dollar funding markets come under stress.
This paper investigates linkages among equity market returns and volatility spillovers in the following countries: Germany, United Kingdom, China, Russia, and Turkey. MARMA, GARCH, GARCH-in-mean, and exponential GARCH (EGARCH) methodologies are applied to daily data on country exchange-traded funds (ETF) based on the MSCI indices from 31 March 2011 to 11 March 2016. The results of the analysis show the existence of significant co-movements of returns among the countries in the sample. ETF returns in Germany, UK, and Russia affect returns in all of the other sample countries. Implications of these findings are explored in terms of portfolio diversification. In addition, the highest volatilities are exhibited by Russia and Turkey. On the other hand, the UK and the Chinese markets have the lowest volatilities. Also, there is a strong evidence of volatility spillovers. All of the countries in the sample, with the exception of UK and Turkey, experience volatility spillovers from other markets. Finally, because of the risk-return trade-off, we analyzed the effect of volatility of the market on its returns and found that only in the UK volatility of the market had a positive effect on its future returns: that an increase in volatility leads to a rise in future ETF returns in the UK.
Abstract: This paper investigates linkages among equity market returns and volatility
spillovers in the following countries: Germany, United Kingdom, China, Russia,
and Turkey. MARMA, GARCH, GARCH-in-mean, and exponential GARCH (EGARCH)
methodologies are applied to daily data on country exchange-traded funds (ETF)
based on the MSCI indices from 31 March 2011 to 11 March 2016. The results of
the analysis show the existence of significant co-movements of returns among the
countries in the sample. ETF returns in Germany, UK, and Russia affect returns in all
of the other sample countries. Implications of these findings are explored in terms
of portfolio diversification. In addition, the highest volatilities are exhibited by Russia
and Turkey. On the other hand, the UK and the Chinese markets have the lowest
volatilities. Also, there is a strong evidence of volatility spillovers. All of the countries
in the sample, with the exception of UK and Turkey, experience volatility spillovers
from other markets. Finally, because of the risk-return trade-off, we analyzed the effect
of volatility of the market on its returns and found that only in the UK volatility
of the market had a positive effect on its future returns: that an increase in volatility
leads to a rise in future ETF returns in the UK.
There has been much debate about the link between global imbalances and the financial crisis of 2007–2008. The most recent contributions show that the recent global financial crisis was preceded not so much by a widening of current account imbalances as by a pronounced increase in gross capital flows between countries. In particular, between 2002 and 2007 several banks from major European countries dramatically increased their long-term assets in dollars, in particular as asset-backed securities (ABS), by stocking up on short-term funding on the interbank market or the money market.
During the 2007–2008 financial crisis several banking systems suffered shortages in U.S. dollars. The liquidity crisis of these banking systems was overcome thanks to the successful intervention of the Federal Reserve that granted swap lines to several central banks, acting as an international lender of last resort. In this paper we show that the Fed’s intervention was motivated principally by its desire to safeguard the stability of the U.S. banking system. For this reason the Fed’s action was expected by the countries whose banking systems had met with a U.S. dollars shortage. In taking for granted the support of the Fed, the authorities of these countries were affected by forms of ex-ante moral hazard, such as the holding of low amounts of official reserves.
This article empirically investigates the determinants of the deviations from fundamental levels of both the currency swap (CRS) and the interest rate swap (IRS) rates in Korea. This study also analyses the inter-linkages between the swap and bond markets in Korea. To this end, a rolling VAR model is estimated incorporating the CRS rate, the IRS rate and the Korean Treasury bond (KTB) rate. It is found that hedging activities and risk factors are significant determinants of the deviations from fundamental levels of the IRS as well as the CRS rate in Korea. Moreover, the covered interest parity (CIP) deviation in the CRS market plays a role in explaining the deviation from the fundamental level of the IRS rate. There are contemporaneous links among the CRS rate, the IRS rate and the KTB rate, and a CRS rate shock significantly affects both the IRS and the KTB rates. © 2014 Wiley Periodicals, Inc. Jrl Fut Mark
The 2008 financial crisis highlighted the challenges associated with global financial integration, emphasized the importance of macro financial linkages and challenged pre-crisis financial stability regimes. Policies in both the macroeconomic and financial sector arenas are now being debated and reviewed, but the debate is currently taking place largely, if not exclusively, in the context of the advanced industrial countries. This is unfortunate, as emerging markets not only face different conditions and have key structural features that can have a bearing on the relevance and efficacy of these policies, but also have had greater experiences with policies aimed at ensuring financial stability.
This volume provides a thorough overview of the evolving macroeconomic and financial stability framework, and the policy options that exist within it. In particular, the volume aims to contribute to a deeper understanding of macro prudential tools, which address systemic risk. This is done in the context of advanced economies as well as emerging markets.
Thus, this volume also reviews the unique risks facing emerging markets specifically, and proposes the policy toolkit available to address these risks. Emerging markets are more exposed to (external) risks than advanced countries, and shocks impact their economies more. This makes macro prudential policies as well as capital flow management tools potentially more useful for emerging markets. In addition, this volume also explores the need for coordination between monetary policies and macro prudential regulation, with an eye on the challenges faced by emerging economies as they cope with this coordination in the current global economic climate
Finally, this volume includes country case studies, outlining the unique experiences of Brazil and the Republic of Korea. Brazil sailed well through the global financial storm. With a focus on specific policies, its case study reviews its recovery in the context of the Brazilian Central Bank’s strong financial sector regulation and macroeconomic management. Korea, on the other hand, faced a set of crisis events in 2008, despite having implemented macro prudential measures prior to the financial crisis. The Korean case study serves to highlight the challenges of implementing macro prudential measures, and their policy objectives and their scope.
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Chapter 1. Adapting Macro Prudential Approaches to Emerging and Developing Economies
Hyun Song Shin
This chapter provides an overview of the policy options that can complement traditional bank regulation and monetary policy tools in reining in financial-sector excesses. Based on existing literature and recent insights, it also provides an analytical framework regarding the motivations for and effects of macro prudential rules on financial institutions.
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Chapter 2. Adapting Micro Prudential Regulation for Emerging Markets
Viral V. Acharya
The financial crisis has led to new micro prudential regulation of financial institutions. This chapter argues that the micro prudential regulatory space (in both advanced and emerging economies) can no longer ignore macro prudential considerations. It concludes with specific important lessons for emerging markets from the crisis and proposed reforms.
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Chapter 3. Capital Flow Volatility and Systemic Risk in Emerging Markets: The Policy Toolkit
Stijn Claessens and Swati R. Ghosh
This chapter reviews the risks facing emerging markets (EMs) and the toolkit available to manage these risks. EMs are more exposed to (external) risks than advanced countries, and shocks impact their economies more. This makes macro prudential policies as well as capital flow management tools potentially more useful for EMs.
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Chapter 4. Monetary Policy and Macro Prudential Regulation: Whither Emerging Markets
Otaviano Canuto and Matheus Cavallari
Confidence in conventional financial stability regimes was shattered by the scale of the financial crisis. This chapter explores the need for coordination between monetary policies and macro prudential regulation. It also points out challenges faced by emerging economies as they cope with this coordination in the current global economic climate.
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Chapter 5. Macro Prudential Policies to Mitigate Financial Vulnerabilities in Emerging Markets
Stijn Claessens, Swati R. Ghosh, and Roxana Mihet
Macro prudential policies have become part of the toolkit of policy makers in many emerging markets and advanced countries. This chapter reviews their analytical foundations, concluding that they offer many potential benefits, especially for emerging markets. This chapter also reviews specific macro prudential policies, focusing on policy design and calibration.
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Chapter 6. Sailing through the Global Financial Storm: Brazil’s recent experience with monetary and macro prudential policies to lean against the financial cycle and deal with systemic risks
Luiz Awazu Pereira da Silva and Ricardo Eyer Harris
Brazil sailed well through the global financial storm. With a focus on specific policies, this chapter reviews its recovery in the context of the Central Bank’s strong financial sector regulation and macroeconomic management. More time is needed to generalize Brazil’s experience and make it a model for other emerging markets.
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Chapter 7. The Operation of Macro prudential Policy Measures: The Case of Korea in the 2000s
Jong Kyu Lee
This chapter reviews the Republic of Korea’s experiences with macro prudential measures, which were in place prior to the financial crisis. Nevertheless, Korea faced a unique set of crisis events in 2008. The Korean case serves to highlight the challenges of macro prudential operations, their policy objectives and their scope.
The expansion of central bank balance sheets and the changes in their composition during financial crises have been effective in rectifying market malfunction and stabilising financial markets in Japan and elsewhere. However, the unconventional policy measures are accompanied by costs, as they are likely to lead to misallocation of resources and to the risk of looser fiscal discipline. An additional possibility is the adverse international transmission of monetary expansion through changes in exchange rates and terms of trade, depending on the price setting behaviour of exporting firms. Even more harmful is the effect on emerging economies when there is financial market disruption in the financial centres.Full publication: Are Central Bank Balance Sheets in Asia Too Large?
Covered interest rate parity allows one to price foreign exchange forwards using no-arbitrage arguments, such that given the rate of risk-free return in both currencies, the forward discount/premium can be determined precisely. This largely held true until mid 2007, when the U.S. sub-prime crisis and subsequent global financial crisis led to U.S. dollar funding constraints that significantly impacted forward prices. We find that factors related to credit risk, funding costs and liquidity influence the forward exchange rate of AUD/USD, EUR/USD and GBP/USD in the post-Lehman period from July 2009 to June 2012, for tenors of 1, 2, 3, 6 months and 1 year.
The Korean economy was hit harder than anticipated by the global financial crisis. In the first phase, large capital outflows led to a severe liquidity strain in the foreign exchange market, resulting in a rapid depreciation of the exchange rate. Then, in the second phase, the contraction of global demand led to a collapse of exports and a sharp decline in economic activity, raising concerns about a full‐fledged financial crisis in Korea. This paper describes how the global financial crisis spilled over into the Korean economy and how the Korean government responded to the financial turmoil. It also provides the background and rationale for the Korean government's decisions to adopt specific policy measures. Based on Korean experiences during the 1997 and the 2008 crises, this paper documents the lessons learned from the past two crises and identifies several important policy issues.
While many believe that Asian regionalism lacks institutions, Asia, in fact, is home to a wide range of regional institutions and frameworks. The rise and fall of regional institutions in Asia is an extremely dynamic process. This paper argues that the dynamic nature of Asian regionalism can be explained by a “regionalism cycle” with regard to membership. The institutional outcomes of regionalism in Asia have been cyclical because the interplay between Japan and the USA has not had a stable equilibrium. This paper tests the hypothesized regionalism cycle using actual cases of regional institutions in the areas of financial cooperation and summit meetings.
The international financial crisis of the late 2000s has revived interest in asset price bubble research. For some, the event confirmed the enduring relevance of studying asset price bubbles in our economies. For others, it was a realisation that asset price bubbles are of much greater significance than previously thought. The financial and policy preconditions that foster "frothy" asset prices which characterise bubbles have been the focus of considerable attention. While doubtless important, it is not the only aspect that requires greater understanding. We also need to develop a better understanding of the whole life-cycle of asset price bubbles, from their origins, to their expansion and spread, the inevitable collapse, and the aftermath that has to be cleaned up. It is increasingly recognised that researchers must not treat bubbles as one-off, exogenous events. The challenge is to develop a more holistic approach, and then build into our policy models endogenous bubble behavior. Such behavior may indeed be rare but nonetheless has its origins in a number of avoidable factors, not least being some combination of financial fragility, flawed policy frameworks, and poor risk management decisions. This paper contributes to our understanding of asset price bubbles by looking at assets when they are severely underpriced, i.e., when there are negative asset price bubbles. Generally, negative asset price bubbles are an underrepresented protagonist in most crisis stories, and this has certainly been the case in the recent international financial crisis. The particular illustration for this paper comes from an examination of the financial market spillovers from the West to Asia and the Pacific. Where did the spillovers come from and how will the crisis end? While there are many different ways to conceptualise the spillovers, this paper will show how cross-border spillovers led to the severe underpricing of various types of assets in Asia and the Pacific. And, just as the policy response to the bursting of the dot-com bubble in the United States may have contributed to the housing problems in the 2000s, there are concerns that accommodative monetary policy in response to the negative asset price bubble and associated macroeconomic fallout may be laying the foundation for a round of positive asset price bubbles. The paper begins with a brief discussion of a negative asset price bubble and a narrative of the international financial crisis in Asia and the Pacific. Prior to September 2008, the international financial crisis had had a limited impact on Asia-Pacific markets. To be sure there were periods of unusual stress but, by and large, the region was more focused on macroeconomic policy issues throughout much of the year. That all changed in late 2008 as the region, despite its strong economic and financial fundamentals, entered what was to become a sharp V-shaped business cycle. Through the lens of a negative asset price bubble perspective, this paper helps to shed new light on the unusual dynamics as well as the policy trade-offs faced during the crisis and afterward. Asia and the Pacific economies are particularly useful "laboratories" to examine these phenomena because of the diverse economic, financial, and policy frameworks in place. The paper also presents a simple model of endogenous asset price bubbles to clarify some of the policy issues. The model assumes there are two regions of the world that are susceptible to domestic asset price bubbles. This type of model emphasises the highly persistent nature of financial shocks associated with boom-bust dynamics and the potential spillovers across geographic borders. An asset price bubble in one economy can influence the likelihood of an asset price bubble in the other economy. Possibly most important, the actions of the policymaker in one region can affect not only the occurrence of a bubble in its domestic market but also the occurrence of a bubble in the other region. This type of model also elevates the importance of tail risk considerations for policymakers, opening up consideration of more complex monetary policy trade-offs than in conventional macroeconomic models. The paper then explores the implications, combining both the narrative from the crisis and the implications of the theoretical model to understand better the regional policy trade-offs that occurred during the international financial crisis. In addition to emphasising the critical importance of having strong economic and financial fundamentals going into a crisis period, it also highlights the value of monetary policymakers adopting state-dependent policy frameworks. During normal times, monetary policy focused on price stability makes sense. During crisis times, the priorities of a central bank may need to be adjusted by putting more weight on financial stability than on short-term inflation stability. This comes down to placing more weight on tail risks when making policy decisions. Practically, this means that short-term deviations from (implicit and explicit) inflation targets may be appropriate, if not optimal, when coming out of a crisis. The paper proceeds as follows. Section 2 lays out the basic intuition of a negative asset price bubble. Section 3 reviews the Asia-Pacific experience during the recent international financial crisis, highlighting aspects of this new bubble perspective. Section 4 then presents a simple international monetary policy model with negative asset price bubbles to explore the theoretical channels of spillovers and the policy trade-offs. Section 5 describes results. Section 6 draws on historical narrative and theoretical findings to evaluate the policy implications. Section 7 offers some conclusions.
During the subprime crisis, the U.S. Federal Reserve has been con- cerned about widening spreads between the overnight inter-bank lend- ing rate such as the overnight index swap (OIS) and term London Inter- Bank Oer Rates (LIBOR). Among the tools it has used to counter the impact of the crisis, the innovative Term Auction Facility (TAF) has attracted a lot of attention. We investigate the impact of TAF on the LIBOR-OIS spread. We find that TAF has a clear initial eect on
This paper examines several key global market conditions, such as a proxy for market uncertainty and measures of interbank funding stress, to assess financial volatility and the likelihood of crisis. Using Markov regime-switching techniques, it shows that the Lehman Brothers failure was a watershed event in the crisis, although signs of heightened systemic risk could be detected as early as February 2007. In addition, we analyze the role of global market conditions to help determine when governments should begin to exit their extraordinary public support measures.
Understanding the global financial crisis and the stresses on bank balance sheets requires a perspective on banks' international investment positions and how these positions were funded across currencies and counterparties. This special feature uses the BIS international banking statistics to identify the cross-currency and counterparty funding patterns for the largest banking systems, and to assess the causes of the US dollar shortage during the critical phases of the crisis.
During the financial crisis, Korea responded to dislocations in the FX swap market by both drawing on its swap line with the Federal Reserve and using its own international reserves to provide dollars to domestic banks. We show that the Bank of Korea's use of the Fed swap line was very effective in alleviating dislocations in the won/dollar FX swap market, whereas the provision of funds using its own foreign reserves was not.
The recent financial crisis saw a dramatic and persistent jump in interest rate spreads between overnight federal funds and longer - term interbank loans. The Fed took several actions to reduce these spreads including the creation of the Term Auction Facility (TAF). The effectiveness of these policies depends on the cause of the increased spreads such as counterparty risk, liquidity, or other factors. Using a no-arbitrage pricing framework and various measures of risk, we find robust evidence that increased counterparty risk contributed to the rise in spreads but do not find robust evidence that the TAF had a significant effect on spreads. (JEL E43, E44, E52, G21)
Banks in the Asian economies most affected by the Asian financial crisis generally continue to enjoy comfortable liquidity in the international interbank market. The apparent international illiquidity of banks in Korea is concentrated in foreign banks. Foreign banks’ offshore funding of local currency assets may in places have created a new vulnerability of local markets and banks to global bank liquidity crunches.
The expectati on of the excess holding yield on a long bond is postulated to depend upon its conditional variance. Engle's ARCH model is extended to allow the conditional variance to be a determinant of the mean and is called ARCH-M. Estimation and infer ence procedures are proposed, and the model is applied to three interest rate data sets. In most cases the ARCH process and the time varying risk premium are highly significant. A collection of LM diagnostic tests reveals the robustness of the model to various specification changes such as alternative volatility or ARCH measures, regime changes, and interest rate formulations. The model explains and interprets the recent econometric failures of the expectations hypothesis of the term structure. Copyright 1987 by The Econometric Society.
We analyse the spillover of the turmoil in money markets in the second half of 2007 to FX swap and long-term cross-currency basis swap markets. We find that the use of swap markets to overcome US dollar funding shortages by non-US financial institutions resulted in marked deviations from covered interest parity conditions and the impairment of liquidity in these markets.
Since December 2008, the Federal Reserve’s traditional policy instrument, the target federal funds rate, has been effectively at its lower bound of zero. In order to further ease the stance of monetary policy as the economic outlook deteriorated, the Federal Reserve purchased substantial quantities of assets with medium and long maturities. In this paper, we explain how these purchases were implemented and discuss the mechanisms through which they can affect the economy. We present evidence that the purchases led to economically meaningful and long-lasting reductions in longer-term interest rates on a range of securities, including securities that were not included in the purchase programs. These reductions in interest rates primarily reflect lower risk premiums, including term premiums, rather than lower expectations of future short-term interest rates.
This paper proposes a new framework which captures the systemic nature of funding liq-uidity risk. Using this framework we develop a set of indicators which measure different aspects of the systemic funding liquidity risk in the interbank foreign currency lending market: (i) systemic funding liquidity needs, (ii) systemic vulnerability, (iii) systemic im-portance and (iv) systemic liquidity shortages. We also analyze the systemic funding liq-uidity risk of the Korean banking system under the new framework. The Korean banking system has become more vulnerable to the systemic funding liquidity risk of foreign cur-rency debt since 2006. The systemic importance of foreign bank branches and the systemic vulnerability of domestic banks have simultaneously increased as the domestic banks have relied heavily on FX swap transactions with foreign bank branches to raise foreign cur-rency funds.
We describe a novel currency investment strategy, the ‘dollar carry trade,’ which delivers large excess returns, uncorrelated with the returns on well-known carry trade strategies. Using a no-arbitrage model of exchange rates we show that these excess returns compensate U.S. investors for taking on aggregate risk by shorting the dollar in bad times, when the U.S. price of risk is high. The counter-cyclical variation in risk premia leads to strong return predictability: the average forward discount and U.S. industrial production growth rates forecast up to 25% of the dollar return variation at the one-year horizon. The estimated model implies that the variation in the exposure of U.S. investors to world-wide risk is the key driver of predictability.Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.
During the subprime crisis, the U.S. Federal Reserve has been concerned about widening spreads between the overnight inter-bank lending rate such as the overnight index swap (OIS) and term London Inter-Bank Offer Rates (LIBOR). Among the tools it has used to counter the impact of the crisis, the innovative Term Auction Facility (TAF) has attracted a lot of attention. We investigate the impact of TAF on the LIBOR-OIS spread. We find that TAF has a clear initial effect on the three-month LIBOR-OIS spread but no sustained effect. In addition, TAF has no effect on the one-month LIBOR-OIS spread, casting further doubt in the usefulness of TAF on reducing risk spreads. Since the subprime crisis has also spilled across the interbank, commercial paper and jumbo mortgage markets, we further examine the lead-lag relationship among LIBOR-OIS, commercial paper and jumbo spreads and the volatility transmission effect among them. For the period before the crisis, we find that the three markets behave independently and do not influence each other. For the subprime crisis period, however, we find that multi-directional lead-lag relationships among these markets and time-varying volatilities across the three markets are significantly correlated.
In most of the currency crises of the 1990s, the largest output falls have occurred in those emerging economies with large currency mismatches, a phenomenon that occurs when assets and liabilities are denominated in different currencies such that net worth is sensitive to changes in the exchange rate. Currency mismatching makes crisis management much more difficult since it constrains the willingness of the monetary authority to reduce interest rates in a recession (for fear of initiating a large fall in the currency that would bring with it large-scale insolvencies). The mismatching also produces a "fear of floating" on the part of emerging economies, sometimes inducing them to make currency-regime choices that are not in their own long-term interest.
The financial crisis that began in 2007 was accompanied by unprecedented funding market dislocations, which spilled across time zones and currencies. The resulting market disruptions triggered policy responses on a global scale, raising questions about the functioning and resilience of the various funding markets on which internationally active banks had relied. This report, prepared by a joint study group of the Committee on the Global Financial System and the Markets Committee, presents an assessment of this episode of global market disruptions. Under the chairmanship of Guy Debelle of the Reserve Bank of Australia, the study group documented in this report the pre-crisis pattern of cross-border funding among internationally active financial institutions, reviewed what happened in various funding markets as the crisis unfolded and the policy responses that ensued, and distilled five policy lessons from the experience.
This paper investigates the spillover effects of money market turbulence in 2007–08 on the short-term covered interest parity (CIP) condition between the US dollar and the euro through the foreign exchange (FX) swap market. Sharp and persistent deviations from the CIP condition observed during the turmoil are found to be significantly associated with differences in the counterparty risk between European and US financial institutions. Furthermore, evidence is found that US dollar term funding auctions by the ECB, supported by US dollar swap lines with the Federal Reserve, alleviated the level of dislocations, as well as the instability, of the FX swap market.
This paper investigates when and how the US dollar shortages evolved into the full crisis in the cross-currency swap market between major European currencies and the US dollar during the turmoil of 2007–2009, using the dynamic factor model with regime-switching β coefficients of each swap price with respect to the latent common factor. The 1-year market entered the high-β crisis regime soon after the onset of the subprime problem in August 2007. The 10-year market entered that regime following the collapse of Bear Sterns in mid-March 2008. Financial credit spreads have significant predictive power for switches between high and low-β regimes.
This paper investigates dislocations in the foreign exchange (FX) swap market between the US dollar and three major European currencies. After the failure of Lehman Brothers in September 2008, deviations from covered interest parity (CIP) were negatively associated with the creditworthiness of US financial institutions (as well as that of European institutions), consistent with the deepening of a dollar liquidity problem into a global phenomenon. US dollar term funding auctions by the ECB, SNB, and BoE, as well as the US Federal Reserve commitment to provide unlimited dollar swap lines are found to have ameliorated the FX swap market dislocations.
During the intensifying integration of the global financial system experienced in recent years FX swap has become one of the most common financial products having the most liquid market. The scope of application of the FX swap transactions is extremely wide; they can be used for liquidity management, risk coverage, short-term yield speculation, and – combined with a spot foreign exchange transaction – for taking exchange rate positions. In recent years the Hungarian banking system financed foreign currency lending mostly from forint funds. Domestic banks typically hedge the resulting on-balance sheet open foreign exchange position by using FX swap transactions concluded with non-residents. Accordingly – with the rise of foreign exchange lending in recent years – the net FX swap stock of the domestic banking system has increased significantly. The FX swap market played a key role during the financial turbulence in 2008, which prompted almost all central banks of the world to take fast and substantial measures. In the case of Hungary the disorder of the FX swap market represents significant risk for the operation of the banking system; thus in recent months the MNB has also taken several liquidity providing measures, due to which the functional disorder of the FX swap market has considerably decreased, simultaneously preserving the stability of the domestic banking system.
Since December 2008, the Federal Reserve's traditional policy instrument, the target federal funds rate, has been effectively at its lower bound of zero. In order to further ease the stance of monetary policy as the economic outlook deteriorated, the Federal Reserve purchased substantial quantities of assets with medium and long maturities. In this paper, we explain how these purchases were implemented and discuss the mechanisms through which they can affect the economy. We present evidence that the purchases led to economically meaningful and long-lasting reductions in longer-term interest rates on a range of securities, including securities that were not included in the purchase programs. These reductions in interest rates primarily reflect lower risk premiums, including term premiums, rather than lower expectations of future short-term interest rates.
We provide robust evidence of a deviation in the covered interest rate parity (CIP) relation since the onset of the financial crisis in August 2007. The CIP deviation exists with respect to several different dollar-denominated interest rates and exchange rate pairings of the dollar vis-a-vis other currencies. The results show that our proxies for margin conditions and for the cost of capital are significant determinants of the CIP deviations, especially during the crisis period. The supply of dollars by the Federal Reserve to foreign central banks via reciprocal currency arrangements (swap lines) reduced CIP deviations at this time. Following the bankruptcy of Lehman Brothers, uncertainty about counterparty risk became a significant determinant of CIP deviations, and the swap lines program no longer affected the CIP deviations significantly. These results indicate a breakdown of arbitrage transactions in the international capital markets that owes partly to lack of capital and partly to heightened counterparty credit risk. Central bank interventions helped reduce the funding liquidity risk of global institutions.
The flow of capital between nations, in principle, brings benefits to both capital-importing and capital-exporting countries. But very large flows can also create new exposures and bring new risks. The failure to analyse and understand such risks, excessive haste in liberalising the capital account and inadequate prudential buffers to cope with the greater volatility in more market-based forms of capital allocation have at one time or another compromised financial or monetary stability in many emerging market economies. On the other hand, rigidities in capital account management can also lead to difficulties in macroeconomic and monetary management. This Report takes stock of the policy debate in this complex area over the past 20 years and examines the vulnerabilities associated with these capital movements. It finds that it is a combination of policies - sound macroeconomic policies, prudent debt management, exchange rate flexibility, the effective management of the capital account, the accumulation of appropriate levels of reserves as self-insurance and the development of resilient domestic financial markets - that provides the optimal response to the large and volatile capital flows to the EMEs. How these elements are best combined will depend on the country and on the period: there is no "one size fits all".
This paper documents that carry traders are subject to crash risk: i.e. exchange rate movements between high-interest-rate and low-interest-rate currencies are negatively skewed. We argue that this negative skewness is due to sudden unwinding of carry trades, which tend to occur in periods in which risk appetite and funding liquidity decrease. Funding liquidity measures predict exchange rate movements, and controlling for liquidity helps explain the uncovered interest-rate puzzle. Carry-trade losses reduce future crash risk, but increase the price of crash risk. We also document excess co-movement among currencies with similar interest rate. Our findings are consistent with a model in which carry traders are subject to funding liquidity constraints.
In the Tract on Monetary Reform, Keynes (1923) conjectured that deviations from covered interest rate parity would not be arbitraged unless a profit of at least a half of one percent on an annualized basis was available, and that larger deviations would still be moderately persistent because of less than perfect elasticity of supply of arbitrage fluids. This two-part conjecture was given further emphasis by other writers on this period, notably Einzig (1937). We apply nonlinear econometric techniques to a previously unexploited weekly data base for the 1920s London and New York markets and find strong support for the conjecture.
This paper examines the effects of the Federal Reserve's Term Auction Facility (TAF) on the London Inter-Bank Offered Rate (LIBOR). The particular question investigated is whether the announcements and operations of the TAF are associated with downward shifts of the LIBOR; such an association would provide one indication of the efficacy of the TAF in mitigating liquidity problems in the interbank funding market. The empirical results suggest that the TAF has helped to ease strains in this market.
This paper examines the effectiveness of the new liquidity facilities that the Federal Reserve established in response to the recent financial crisis. I develop a no-arbitrage based affine term structure model with default risk and conduct a thorough factor analysis of the counterparty default risk among major financial institutions and the underlying mortgage default risk. The new facilities' effectiveness is examined, by first separately examining their effects in relieving financial institutions' liquidity concerns and reducing the counterparty risk premiums, and then quantifying their overall effects in reducing financial strains in the inter-bank money market. ; Empirical results indicate that the Term Auction Facility (TAF) has a strong effect in reducing financial strains in the inter-bank money market, primarily through relieving financial institutions' liquidity concerns. Heightened uncertainty regarding the macroeconomy, financial markets, and mortgage default risk have significantly raised counterparty risk premiums among financial institutions, but have had little effect on their liquidity premiums. The Term Securities Lending Facility (TSLF) and the Primary Dealer Credit Facility (PDCF), however, are found to have had less discernible effects so far in relieving financial strains in the Libor market. This is consistent with market observations of a weaker interest from primary dealers in participating in the TSLF auctions than banks have shown in tapping the TAF.
This paper explores the nature of default arrival and recovery implicit in the term structures of sovereign "CDS" spreads. We argue that term structures of spreads reveal not only the arrival rates of credit events , but also the loss rates given credit events. Applying our framework to Mexico, Turkey, and Korea, we show that a single-factor model with following a lognormal process captures most of the variation in the term structures of spreads. The risk premiums associated with unpredictable variation in are found to be economically significant and co-vary importantly with several economic measures of global event risk, financial market volatility, and macroeconomic policy. Copyright (c) 2008 The American Finance Association.
This paper introduces an ARCH model (exponential ARCH) that (1) allows correlation between returns and volatility innovations (an important feature of stock market volatility changes), (2) eliminates the need for inequality constraints on parameters, and (3) allows for a straightforward interpretation of the "persistence" of shocks to volatility. In the above respects, it is an improvement over the widely-used GARCH model. The model is applied to study volatility changes and the risk premium on the CRSP Value-Weighted Market Index from 1962 to 1987. Copyright 1991 by The Econometric Society.
This paper is of interest both for its methodological contribution of new tools for analyzing rational-expectations models and for its substantive conclusions concerning the term structure of interest rates during the monetary experiment of October 1979.The paper studies systems subject to changes in regime, interpreted here as occasional, discrete shifts in the parameters governing the time series behavior of exogenous economic variables. The specification is shown to be quite tractable both theoretically and empirically. The technique is used to analyze yields on three-month Treasury bills and ten-year Treasury bonds during 1962 to 1987. A constant-parameter linear model for short-term rates is shown to be inconsistent both with the univariate time series properties of short rates and with the observed bivariate relation between long and short rates under the expectations hypothesis of the term structure. AN alternative nonlinear model that admits the possibility of changes in regime affords a much better description of the univariate process for short rates. Moreover, the cross-equation restrictions implied by the expectations hypothesis of the term structure are consistent with the nonlinear specification. Indeed, the residuals of the restricted relation have a standard error of only 0.8 basis points. This is a third less than that of a completely unrestricted linear regression of long rates on short rates, and compares with an unconditional standard deviation of long rates of 142 basis points.I conclude that once the recognition by bond traders of changes in regime is taken into account, the expectations hypothesis of the term structure of interest rates holds up fairly well for these data.
This paper models occasional, discrete shifts in the growth rate of a nonstationary series. Algorithms for inferring these unobserved shifts are presented, a byproduct of which permits estimation of parameters by maximum likelihood. An empirical application of this technique suggests that the periodic shift from a positive growth rate to a negative growth rate is a recurrent feature of the U.S. business cycle, and indeed could be used as an objective criterion for defining and measuring economic recessions. The estimated parameter values suggest that a typical economic recession is associated with a 3 percent permanent drop in the level of GNP. Copyright 1989 by The Econometric Society.
This article explores the evolution of capital flows to emerging markets over the last 30 years with emphasis on the past decade. Capital markets in emerging-market economies have evolved substantially over the period, becoming increasingly deep and resilient. The author looks at how capital flows to these countries have changed in terms of magnitude, geographical distribution, the financial instruments used, and the country of origin. He also examines how changes in the investor base have affected these flows and reviews the factors underlying the growth of private capital flows in the 1990s.
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