Impact of the Financial Crisis on the Exchange Rate
International Economics and Business Department
“Impact of financial crisis on exchange rate”
Table of Contents INTRODUCTION 3 1. Comparison of three episodes 5 2. INTEREST RATE DIFFERENTIALS AND EXCHANGE RATE CHANGES 12 Conclusion 17 References 18
INTRODUCTION
Financial crises are often associated with significant movements in exchange rates, which reflect both increasing risk aversion and changes in the perceived risk of investing in certain currencies. The global financial crisis of 2007–09 was no exception. Previous work on exchange rate movements during the crisis has concentrated on the unusual (and unexpected) appreciation of the US dollar (McCauley and McGuire (2009), McGuire and von Peter (2009)). This feature investigates the flip side of this development and focuses on movements in the exchange rates of a number of emerging markets and small advanced economies against three major currencies: the Japanese yen, the Swiss franc and the US dollar. During the crisis, a large number of currencies that were not at the centre of the turmoil depreciated. These movements reversed within a year or so. Both these experiences stand out when compared with those seen during the Asian financial crisis of 1997–98 or the crisis that followed the Russian debt default in mid-1998. We concentrate on two factors that can explain part of these unusual developments. First, during the most recent episode safe haven flows went against the typical crisis-related pattern: instead of fleeing the country at the epicentre of the crisis, they moved into it. Second, interest rate differentials played a bigger role than in the past in explaining some of the crisis-related exchange rate movements. The increase in carry trade activity over the past 15 years could be one explanation for this finding. If so, the dynamics of exchange rate movements around crises may have changed more fundamentally. In the next
“Impact of financial crisis on exchange rate”
Table of Contents INTRODUCTION 3 1. Comparison of three episodes 5 2. INTEREST RATE DIFFERENTIALS AND EXCHANGE RATE CHANGES 12 Conclusion 17 References 18
INTRODUCTION
Financial crises are often associated with significant movements in exchange rates, which reflect both increasing risk aversion and changes in the perceived risk of investing in certain currencies. The global financial crisis of 2007–09 was no exception. Previous work on exchange rate movements during the crisis has concentrated on the unusual (and unexpected) appreciation of the US dollar (McCauley and McGuire (2009), McGuire and von Peter (2009)). This feature investigates the flip side of this development and focuses on movements in the exchange rates of a number of emerging markets and small advanced economies against three major currencies: the Japanese yen, the Swiss franc and the US dollar. During the crisis, a large number of currencies that were not at the centre of the turmoil depreciated. These movements reversed within a year or so. Both these experiences stand out when compared with those seen during the Asian financial crisis of 1997–98 or the crisis that followed the Russian debt default in mid-1998. We concentrate on two factors that can explain part of these unusual developments. First, during the most recent episode safe haven flows went against the typical crisis-related pattern: instead of fleeing the country at the epicentre of the crisis, they moved into it. Second, interest rate differentials played a bigger role than in the past in explaining some of the crisis-related exchange rate movements. The increase in carry trade activity over the past 15 years could be one explanation for this finding. If so, the dynamics of exchange rate movements around crises may have changed more fundamentally. In the next
References: Baig, T and I Goldfajn (2000): “The Russian default and the contagion to Brazil”, IMF Working Paper, no 00/160. Bank for International Settlements (1999): “Developments in foreign exchange markets”, 79th Annual Report, Chapter VI, pp 103–19 Bliss, R R and N Panigirtzoglou (2004): “Option-implied risk aversion estimates”, Journal of Finance, no 59(1), pp 407–46.