International Finance - Adrien Verdelhan (MIT) and Nick Roussanov (Wharton) [Summer Lecture #2]

Adrien Verdelhan (MIT) and Nikolai Roussanov (Wharton) give lecture on International Finance "Macro Finance Across Borders". In particular, they touch on topics of exchange rates formation (forex/currency market), deviations from the Covered Interest Rate Parity, and the importance of the Dollar. This is the second lecture in Macro Finance Society-Wharton Virtual Summer School 2020: “Open Questions in Macro Finance,” August 2020

Here you can find the full schedule of the MFS-Wharton Virtual Summer School:

Macro-finance addresses the link between asset prices and economic fluctuations. Macroeconomics (from the Greek prefix makro- meaning "large" + economics) is a branch of economics dealing with the performance, structure, behavior, and decision-making of an economy as a whole. Macroeconomists study topics such as GDP, unemployment rates, national income, price indices, output, consumption, unemployment, inflation, saving, investment, energy, international trade, and international finance. Asset prices are the prices for which financial instruments, such as stocks, bonds, currencies, etc., are bought and sold.

International finance (also referred to as international monetary economics or international macroeconomics) is the branch of financial economics broadly concerned with monetary and macroeconomic interrelations between two or more countries. International finance examines the dynamics of the global financial system, international monetary systems, balance of payments, exchange rates, foreign direct investment, and how these topics relate to international trade.

The foreign exchange market (Forex, FX, or currency market) is a global decentralized or over-the-counter (OTC) market for the trading of currencies. This market determines foreign exchange rates for every currency. Interest rate parity is a no-arbitrage condition representing an equilibrium state under which investors will be indifferent to interest rates available on bank deposits in two countries. The fact that this condition does not always hold allows for potential opportunities to earn riskless profits from covered interest arbitrage.
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Chat from the meeting:
00:26:32 Sun Yong Kim: Froot and Ramodarai decomposition assumes that the real exchange rate is stationary (imposing transversality condition on long run exchange rate). In other words deviations from PPP eventually die out. Is this really a non-trivial assumption? At least for emerging market countries, balassa-samuelson effects for example can lead to persistent deviations in PPP.
00:31:28 Jay Im: Is there any standard framework to think about the exchange rate relationship to real macro-economic quantities like consumption, investment, saving, asset price and etc.?
For instance, are there any quick results like "if country A to B exchange rate increases then C/I/S/P (increase/decrease)? I would like to think if exchange rate matters for classical macro-economic quantities.
00:34:03 Sun Yong Kim: We know from Backus-Smith that consumption growths are disconnected from exchange rates. How do I reconcile that with the fact that carry trades formed on consumption growths are profitable according to Lustig and Verdelhan (2007)?
00:44:26 Nina Karnaukh: Feel free to raise your hand if you want to ask your question "in person"
00:58:09 Alessandro Rebucci: Can you comment on how the new work on demand factors by Stein et al and POG-Vayanos fit in?
00:58:36 Sun Yong Kim: Sandulescu, Trojani and Vedolin (2019) argue that the asset market view (real exchange is difference in log SDFs) can even hold in special cases when markets are incomplete but integrated. Since developed markets are highly integrated, can the asset market view still be approximately true in this setting?
00:59:06 Nick Roussanov: @Alessandro - I plan to talk about this towards the end!
00:59:16 Alessandro Rebucci: great.
01:01:40 Xiang Fang: When market is incomplete, one thing we need to take a stand is the available asset menus. For example, the recent paper by Camanho-Hau-Rey treats exchange rate to be determined by equity flows. We may also think debt flows matter. Can you comment on what kind of stand you prefer? Do they matter and how? If a model result relies heavily on the asset market structure, is that a good or bad thing?
01:11:51 Nina Karnaukh: Would be very interesting to see the CIP deviations in 2020
01:19:03 Nobuhiro Abe: Could you please let us know your interpretation for the difference of the direction of deviation fo CIP between JPY and AUD? Is there any consensus in academia?
01:22:30 Nina Karnaukh: Was there any interesting behavior in the (1w) CIP deviations in the end of the quarter before 2008? Were the reporting requirements different then?
01:22:58 Sun Yong Kim: It seems to me that the CIP deviations is tied to the fact that banks are marginal in FX markets. If this were to change (due to financial innovation ) so that the marginal investor shifts to a more retail investor (maybe algorithmic traders), would you expect these CIP deviations to disappear over time? The minutia of banking regulations are unlikely to matter to these investors.
01:24:33 Luke Min: In light of your previous comment on your preferred approach (i.e. let’s think about who has access to which markets), could you say more about the type of agents that have access to the arbitrage trades that would close this CIP gap? Are they mostly banks? Where are the hedge funds? What kind of access to capital do they need to execute the trade? (uncollaterized borrowing perhaps?)
01:27:29 Alessandro Rebucci: One important thing is that this is not a unified market, although linked to the “plumbing” of the US financial system that has had troubles functioning properly.
01:36:47 Xiang Fang: How does central bank intervention affects currency risk premia (some countries have crawling peg, some managed floating, etc). How to think about it?
01:47:52 Sun Yong Kim: Just a comment: I notice that in Adrien’s slides exchange rates are quoted relative to USD. Does the numeraire matter for exchange rate factor structure? I would think given literature on special role of USD it shouldn’t be a big issue but interested in your thoughts.
01:53:00 Nina Karnaukh: let's applaud!
02:13:30 Sun Yong Kim: Does it still make sense to use forward discounts to measure carry trade returns given the last session on pervasive CIP violations?
02:53:03 Sun Yong Kim: It seems to me that the reason why the dollar carry trade is informative of global risk is because the US has average exposure to the global shock relative to non-US countries. Is the US exception in this regard? If other base countries (maybe Euro) have average global exposure relative to the outside world, does this imply these other base factor carry trades should also be informative of global risk?
02:53:15 Sun Yong Kim: *exceptional
03:06:09 Nina Karnaukh: Do you think that the special role of the U.S. policy for the FX markets may also be related to the high share of USD (88%) in total FX trading and also dominance of the dollar in the global trade invoicing and corporate/government bond borrowing?
03:06:59 Xiang Fang: What is the role of average foreign interest rate in predicting currency returns? If we use US interest rate only as a predictor, will the result be similar?
03:09:14 Sun Yong Kim: How do you think of the emerging market carry trade? according to Hassan and Mano (2019), carry trade profitability is tied to UIP violations: but we know from Burnside (2014) that evidence against UIP is significantly weaker for emerging markets yet emerging market carry trade is still very profitable.
03:23:28 Nina Karnaukh: lets send likes
03:23:33 Bhavyaa Sharma: Thank you so much Adrien and Nick for an amazing session!
03:23:38 Ilja Kantorovitch: Thank you very much Adrien and Nick!!