Essays on interest rate and currency markets

Abstract

In chapter 1 we put forward a simple method of estimating individual G10 currency returns from observed exchange rates via a Bayesian approach. As an application of this technique, we replace US dollar denominated portfolios in Lustig, Roussanov and Verdelhan (2011) and Menkhoff et al (2012) with US dollar-independent portfolios that are valued in terms of a ``neutral'' numeraire. This renders unnecessary the US dollar factor introduced by the papers and permits the US dollar to be included as a portfolio currency. We find that the S&P500 index returns are positively associated with carry trade returns, with a higher significance compared to currency volatility. This supports the view that global market risk sentiment drives carry trade returns, rather than volatility per se.

In chapter 2, we investigate deviations from covered interest rate parity (CIP), which is used to price forward exchange rates. CIP held 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 deviations in the forward exchange rate from CIP 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.

In chapter 3 we gather 34 macroeconomic data series over 8 years from the US and Eurozone and split them into 4 groups: US inflation, US growth, Eurozone inflation and Eurozone growth. We summarise the data for each group using the first principal component of the series from each group. Additionally, we produce mutually orthogonal components using a variation on principal component analysis. We find that before mid-2008, US inflation and growth factors are positively related to US and Eurozone yield level and yield slope, although this relationship vanishes in the post-2008 period. This points to other factors directly driving yields, such as fiscal and monetary policy announcements.