Optimal Currency Shares in International Reserves: The Impact of the Euro and the Prospects for the Dollar

Foreign exchange reserve accumulation has risen dramatically in recent years. The introduction of the euro, greater liquidity in other major currencies, and the rising current account deficits and external debt of the United States have increased the pressure on central banks to diversify away from the US dollar. A major portfolio shift would significantly affect exchange rates and the status of the dollar as the dominant international currency. We develop a dynamic mean-variance optimization framework with portfolio rebalancing costs to estimate optimal portfolio weights among the main international currencies. Making various assumptions on expected currency returns and the variance-covariance structure, we assess how the euro has changed this allocation. We then perform simulations for the optimal currency allocations of four large emerging market countries (Brazil, Russia, India and China), adding constraints that reflect a central bank%u2019s desire to hold a sizable portion of its portfolio in the currencies of its peg, its foreign debt and its international trade. Our main results are: (i) The optimizer can match the large share of the US dollar in reserves, when the dollar is the reference (risk-free) currency. (ii) The optimum portfolios show a much lower weight for the euro than is observed. This suggests that the euro may already enjoy an enhanced role as an international reserve currency ("punching above its weight"). (iii) Growth in issuance of euro-denominated securities, a rise in euro zone trade with key emerging markets, and increased use of the euro as a currency peg, would all work towards raising the optimal euro shares, with the last factor being quantitatively the most important.

Democratic Reforms, Foreign Aid and Production Inefficiency

We construct an endogenous growth model and we employ empirical analysis to investigate the link between foreign aid and production efficiency in the presence of different political orientations of the recipient country. Using a panel of 124 countries from 1971 to 2007 and the production frontier toolbox, we document that regardless of income stratum, decade and type, foreign aid is associated with higher production inefficiency and that this inefficiency is reduced considerably if countries switch to democratic governance. Our study contributes to the aid literature by pointing to the institutional enhancement of the recipient countries through initially the adoption of democratic ruling practices.Democratic reforms, foreign aid, production inefficiency, translog function

Optimal currency shares in international reserves: the impact of the euro and the prospects for the dollar

Foreign exchange reserve accumulation has risen dramatically in recent years. The introduction of the euro, greater liquidity in other major currencies, and the rising current account deficits and external debt of the United States have increased the pressure on central banks to diversify away from the US dollar. A major portfolio shift would significantly affect exchange rates and the status of the dollar as the dominant international currency. We develop a dynamic mean-variance optimization framework with portfolio rebalancing costs to estimate optimal portfolio weights among the main international currencies. Making various assumptions on expected currency returns and the variance-covariance structure, we assess how the euro has changed this allocation. We then perform simulations for the optimal currency allocations of four large emerging market countries (Brazil, Russia, India and China), adding constraints that reflect a central bank’s desire to hold a sizable portion of its portfolio in the currencies of its peg, its foreign debt and its international trade. Our main results are: (i) The optimizer can match the large share of the US dollar in reserves, when the dollar is the reference (risk-free) currency. (ii) The optimum portfolios show a much lower weight for the euro than is observed. This suggests that the euro may already enjoy an enhanced role as an international reserve currency ("punching above its weight"). (iii) Growth in issuance of euro-denominated securities, a rise in euro zone trade with key emerging markets, and increased use of the euro as a currency peg, would all work towards raising the optimal euro shares, with the last factor being quantitatively the most important. JEL Classification: F02, F30, G11, G15Currency optimizer, euro, Foreign reserves, international currencies

Essays on exchange rates, capital flows and growth

My thesis comprises of two parts. The first part consists of two chapters. The first chapter titled "A Model of Real Exchange Rates and Real Consumption Spending with Time Varying Discount Factors" generalizes a "no-arbitrage" or "real business cycle" equilibrium model by allowing for different time varying impatience parameters across countries and provides empirical evidence for this model vis-ä-vis a restricted one, where impatience parameters are constant. My contribution is to show, based on a generalization of the equilibrium model of exchange rates, that the test equation linking exchange rates to fundamentals should allow for heterogeneity in time preferences across countries and across time, as well as noise-that is the model should not be tested as an exact relation. The second chapter titled "Capital Flows and Exchange Rates" investigates the empirical relationship between capital flows and nominal exchange rates for five major countries. Recent international finance theory suggests that currencies are influenced by capital flows as much as by current account balances and log-term interest rates. Using Vector Auto Regressions (VAR's) I document the following: Incorporating net cross-border equity flows into linear exchange rate models can improve their in-sample performance. Using net cross-border bond flows, however, has no such effect; (ii) An equity-augmented linear model supports exchange rate predictability and outperforms a random walk in several cases. The second part of my thesis consists also of two chapters (co-authored with Elias Papaioannou, LBS). In the third chapter titled "Democratization and Growth" we revisit the relationship between democracy and growth. Addressing several drawbacks of previous studies yields new evidence: (i) A permanent democratization results in a positive and significant increase of real per capita GDP growth of approximately one percent. (ii) A J-shaped dynamic pattern emerges, with output costs around the transition, but significantly positive growth gains after democracy's stabilization. The empirical evidence thus validates Hayek's (1960) insight that "the merits of democracy will only come in the long-run". The fourth chapter titled "What Drives Democracy? " is directly linked to the previous one since it aims to explore further the endogenous formation of democratization. We examine countries that enter our sample as non-democratic to identify the systematic factors that led certain countries to abandon autocracy permanently. This approach stands in contrast to the limited empirical studies that pool all countries to quantify the correlates of long-run democracy. We document that: (i) In contrast to recent studies that challenge the income-freedom link, a permanent democratization is more likely to occur in wealthy (but not oil-abundant) countries. ii) In line with the liberal hypothesis (Friedman, 1962), economic and political liberalizations appear to be re-enforcing. (iii) Democratic transitions are more likely to occur after an economic crisis. (iv) Beyond economic factors, religion and fractionalization are key determinants of political systems

Democratic Reforms, Foreign Aid and Production Inefficiency

We construct an endogenous growth model and we employ empirical analysis to investigate the link between foreign aid and production efficiency in the presence of different political orientations of the recipient country. Using a panel of 124 countries from 1971 to 2007 and the production frontier toolbox, we document that regardless of income stratum, decade and type, foreign aid is associated with higher production inefficiency and that this inefficiency is reduced considerably if countries switch to democratic governance. Our study contributes to the aid literature by pointing to the institutional enhancement of the recipient countries through initially the adoption of democratic ruling practices.Democratic reforms, foreign aid, production inefficiency, translog function

Superkurtosis

Very little is known on how traditional risk metrics behave in ultra high frequency trading (UHFT). We fi�ll this void �firstly by examining the existence of the intraday returns moments, and secondly by assessing the impact of their (non)existence in a risk management framework. We show that in the case of UHFT, the returns' third and fourth moments do not exist, which entails that traditional risk metrics are unable to judge capital adequacy adequately. Hence, the use of risk management techniques, such as VaR, by market participants who engage with UHFT impose serious threats to the stability of fi�nancial markets, given that capital ratios may be severely underestimated

Democratic Reforms, Foreign Aid and Production Inefficiency

We construct an endogenous growth model and we employ empirical analysis to investigate the link between foreign aid and production efficiency in the presence of different political orientations of the recipient country. Using a panel of 124 countries from 1971 to 2007 and the production frontier toolbox, we document that regardless of income stratum, decade and type, foreign aid is associated with higher production inefficiency and that this inefficiency is reduced considerably if countries switch to democratic governance. Our study contributes to the aid literature by pointing to the institutional enhancement of the recipient countries through initially the adoption of democratic ruling practices

Superkurtosis

Very little is known on how traditional risk metrics behave in ultra high frequency trading (UHFT). We fi�ll this void �firstly by examining the existence of the intraday returns moments, and secondly by assessing the impact of their (non)existence in a risk management framework. We show that in the case of UHFT, the returns' third and fourth moments do not exist, which entails that traditional risk metrics are unable to judge capital adequacy adequately. Hence, the use of risk management techniques, such as VaR, by market participants who engage with UHFT impose serious threats to the stability of fi�nancial markets, given that capital ratios may be severely underestimated

Superkurtosis

Very little is known on how traditional risk metrics behave under intraday trading. We fill this void by examining the finiteness of the returns' moments and assessing the impact of their infinity in a risk management framework. We show that when intraday trading is considered, assuming finite higher order moments, potential losses are materially larger than what the theory predicts, and they increase exponentially as the trading frequency increases - a phenomenon we call superkurtosis. Hence, the use of the current risk management techniques under intraday trading impose threats to the stability of financial markets, given that capital ratios may be severely underestimated

Exchange rate uncertainty and international portfolio flows: A multivariate GARCH-in-mean approach

This paper examines the impact of exchange rate uncertainty on different components of net portfolio flows, namely net equity and net bond flows, as well as their dynamic linkages. Specifically, a bivariate VAR GARCH-BEKK-in-mean model is estimated using bilateral monthly data for the US vis-à-vis Australia, Canada, the euro area, Japan, Sweden, and the UK over the period 1988:01-2011:12. The results indicate that the effect of exchange rate uncertainty on net equity flows is negative in the euro area, the UK and Sweden, and positive in Australia. The impact on net bond flows is also negative in all countries except Canada, where it is positive. Under the assumption of risk aversion, the findings suggest that exchange rate uncertainty induces a home bias and causes investors to reduce their financial activities to maximise returns and minimise exposure to uncertainty, this effect being stronger in the UK, the euro area and Sweden compared to Canada, Australia and Japan. Overall, the results indicate that exchange rate or credit controls on these flows can be used as a policy tool in countries with strong uncertainty effects to pursue economic and financial stability