That reflects the high monetary policy uncertainty, argue Alireza Tahbaz-Salehi, Andrea Vedolin and Philippe Muelle

Mueller, Philippe

Tahbaz-Salehi, Alireza

Vedolin, Andrea

LSE Research Online

2/18/2016Some currency trading positions yield increased returnsaround Fed announcementsblogs.lse.ac.uk /businessreview/2016/02/18/some-currency-trading-positions-lead-to-increased-returns-around-fed-announcements/Announcements by the Federal Open Market Committee (FOMC), which occur regularly at pre-specified dates, areone of the most highly anticipated events by investors around the world. Through these announcements, the FederalReserve communicates monetary policy in the form of setting the target federal funds rate which is the interest rateat which financial institutions lend to each other overnight.In a recent paper, we study the effect of central bank announcements on the currency market. Given the close linkbetween currency markets and monetary policy, it is only natural to expect that FOMC announcements can havelarge impacts on exchange rates. Indeed, this was illustrated recently by the announcement on 18 March 2015,when the Australian dollar appreciated more than 2 percent against the U.S. dollar within a few hours in the run-upto the announcement (corresponding to a three standard-deviation daily change), followed by a 1.6 percentdepreciation right after the announcement.The active nature of the currency markets (with a daily turnover of over USD 5 trillion), coupled with high marketconcentration and the participants’ ability to operate with very high leverage ratios, means that even small pricemovements in this market can translate into economically significant effects. For example, according to the Bank ofInternational Settlements, USD 364 billion are traded daily in the AUD-USD market (compared to USD 30 trilliontraded on the NYSE). Therefore as a back of the envelope calculation, a 2 percent appreciation of the AustralianDollar against the U.S. dollar results in a USD 7.28 billion move which, given the high leverage ratios, a 1 percentmargin is typical, implies a USD 728 billion movement in investors’ balance sheets.In this paper, we document that announcements by the FOMC have an economically and statistically significantimpact on the excess returns of a host of different currencies vis-a-vis the U.S. dollar. More specifically, by relying onhigh-frequency data, we document that a trading strategy that is short the U.S. dollar and long other currenciesexhibits significantly larger excess returns on days with scheduled FOMC announcements relative to non-announcement days. Crucially, the excess returns earned by following such a strategy span the entire1/3announcement day, consisting of a pre- as well as a post-announcement component. We also document that theseexcess returns (i) are higher for currencies with higher interest rate differentials vis-a-vis the U.S.; (ii) increase withmarket participants’ uncertainty about monetary policy; and (iii) intensify when the Fed adopts a policy of monetaryeasing.We interpret these findings through the lens of a parsimonious model of exchange rate determination, in whichconstrained financiers with short investment horizons intermediate global demand for currencies. These financierscan actively engage in currency trades, but have a downward-sloping demand for risk taking, which limits their risk-bearing capacity. Such a limit can arise for a variety of reasons, such as limited commitment frictions or value-at-riskconstraints. Higher currency returns during announcement days are meant to compensate investors for theuncertainty in monetary policy, hence, even if the Federal Reserve does not take any action or leaves the targetfederal funds rate as is, investors will earn a premium for holding the currency during these risky days. This is whatwe label the pre-announcement return. In addition to this effect, however, the actual realization of the monetarypolicy shock (i.e. whether the Federal Reserve ultimately changes the interest rate) also has an effect, leading towhat we call the post-announcement effect. Indeed, we know that an ex post adoption of an expansionary monetarypolicy (corresponding to an interest rate reduction by the Fed) further increases currency returns.To empirically study currency risk premia around announcement days, we use 20 years of high-frequency data forthe ten most traded currencies. We find that, in line with our theoretical model, a simple trading strategy that is shortthe U.S. dollar and long the other currencies yields economically significant returns on announcement dayscompared to non-announcement days. Furthermore, we document that returns earned on the eight announcementday account for a significant fraction of the currencies’ yearly excess returns. Crucially, we also find that currenciesexhibit excess returns that span the entire announcement day, consisting of a pre- and a post-announcementcomponent, as predicted by our model.Our explanation for these large returns around announcement days is that they reflect a premium for heightenedmonetary policy uncertainty or more generally a tightening of financiers’ risk-bearing capacity. Using differentproxies for monetary policy uncertainty (such as an implied volatility index from Treasury futures options and anuncertainty measure constructed from survey forecasts about the future federal funds rate), we find that an increasein market participants’ uncertainty is indeed associated with higher returns around FOMC announcement days. ♣♣♣Notes:This post is based on the authors’ paper Exchange Rates and Monetary Policy Uncertainty (December 2015),LSE’s  Systemic Risk Centre.This post gives the views of its authors, not the position of LSE Business Review or the London School ofEconomics.Featured image credit: Wall Street, by Butz.2013 CC-BY-2.0Alireza Tahbaz-Salehi is Daniel W. Stanton Association Professor of Business at ColumbiaBusiness School. His research focuses on the implications of network economies for businesscycle fluctuations and financial stability.  2/3Andrea Vedolin is an assistant professor in the Department of Finance  at the London School ofEconomics and Political Science. Her research focuses on theoretical and empirical asset pricing.  Philippe Mueller is an assistant professor in the Department of Finance at the London School ofEconomics and Political Science. His research interests are in financial econometrics, empiricalasset pricing and macro-finance.   Copyright © 2015 London School of Economics3/3

Some currency trading positions yield increased returns around Fed announcements

The announcements of the Federal Reserve Bank can have huge impacts on the world currency market. Alireza Tahbaz-Salehi, Andrea Vedolin and Philippe Muelle argue that these impacts reflects the high degree of monetary policy uncertainty

Muelle, Philippe

blogs.lse.ac.ukhttp://blogs.lse.ac.uk/usappblog/2016/02/20/some-currency-trading-positions-yield-increased-returns-around-fed-announcements/Some currency trading positions yield increased returns aroundFed announcementsThe announcements of the Federal Reserve Bank can have huge impacts on the world currencymarket. Alireza Tahbaz-Salehi, Andrea Vedolin and Philippe Muelle argue that these impactsreflects the high degree of monetary policy uncertainty.Announcements by the Federal Open Market Committee (FOMC), which occur regularly at pre-specified dates, are one of the most highly anticipated events by investors around the world.Through these announcements, the Federal Reserve communicates monetary policy in the form ofsetting the target federal funds rate which is the interest rate at which financial institutions lend toeach other overnight.In a recent paper, we study the effect of central bank announcements on the currency market.Given the close link between currency markets and monetary policy, it is only natural to expect thatFOMC announcements can have large impacts on exchange rates. Indeed, this was illustratedrecently by the announcement on 18 March 2015, when the Australian dollar appreciated more than2 percent against the U.S. dollar within a few hours in the run-up to the announcement(corresponding to a three standard-deviation daily change), followed by a 1.6 percent depreciationright after the announcement.The active nature of the currency markets (with a daily turnover of over USD 5 trillion), coupledwith high market concentration and the participants’ ability to operate with very high leverageratios, means that even small price movements in this market can translate into economicallysignificant effects. For example, according to the Bank of International Settlements, USD 364 billion are traded dailyin the AUD-USD market (compared to USD 30 trillion traded on the NYSE). Therefore as a back of the envelopecalculation, a 2 percent appreciation of the Australian Dollar against the U.S. dollar results in a USD 7.28 billionmove which, given the high leverage ratios, a 1 percent margin is typical, implies a USD 728 billion movement ininvestors’ balance sheets.In this paper, we document that announcements by the FOMC have an economically and statistically significantimpact on the excess returns of a host of different currencies vis-a-vis the U.S. dollar. More specifically, by relying onhigh-frequency data, we document that a trading strategy that is short the U.S. dollar and long other currenciesexhibits significantly larger excess returns on days with scheduled FOMC announcements relative to non-announcement days. Crucially, the excess returns earned by following such a strategy span the entireannouncement day, consisting of a pre- as well as a post-announcement component. We also document that theseexcess returns (i) are higher for currencies with higher interest rate differentials vis-a-vis the U.S.; (ii) increase withmarket participants’ uncertainty about monetary policy; and (iii) intensify when the Fed adopts a policy of monetaryeasing.We interpret these findings through the lens of a parsimonious model of exchange rate determination, in whichconstrained financiers with short investment horizons intermediate global demand for currencies. These financierscan actively engage in currency trades, but have a downward-sloping demand for risk taking, which limits their risk-bearing capacity. Such a limit can arise for a variety of reasons, such as limited commitment frictions or value-at-riskconstraints. Higher currency returns during announcement days are meant to compensate investors for theuncertainty in monetary policy, hence, even if the Federal Reserve does not take any action or leaves the targetfederal funds rate as is, investors will earn a premium for holding the currency during these risky days. This is whatwe label the pre-announcement return. In addition to this effect, however, the actual realization of the monetarypolicy shock (i.e. whether the Federal Reserve ultimately changes the interest rate) also has an effect, leading towhat we call the post-announcement effect. Indeed, we know that an ex post adoption of an expansionary monetarypolicy (corresponding to an interest rate reduction by the Fed) further increases currency returns.To empirically study currency risk premia around announcement days, we use 20 years of high-frequency data forthe ten most traded currencies. We find that, in line with our theoretical model, a simple trading strategy that is shortthe U.S. dollar and long the other currencies yields economically significant returns on announcement dayscompared to non-announcement days. Furthermore, we document that returns earned on the eight announcementday account for a significant fraction of the currencies’ yearly excess returns. Crucially, we also find that currenciesexhibit excess returns that span the entire announcement day, consisting of a pre- and a post-announcementcomponent, as predicted by our model.Our explanation for these large returns around announcement days is that they reflect a premium for heightenedmonetary policy uncertainty or more generally a tightening of financiers’ risk-bearing capacity. Using differentproxies for monetary policy uncertainty (such as an implied volatility index from Treasury futures options and anuncertainty measure constructed from survey forecasts about the future federal funds rate), we find that an increasein market participants’ uncertainty is indeed associated with higher returns around FOMC announcement days.Featured image credit: Wall Street, by Butz.2013 CC-BY-2.0This article was originally posted on LSE Business Review, and is based on the authors’ paper Exchange Rates andMonetary Policy Uncertainty (December 2015), LSE’s  Systemic Risk Centre.Please read our comments policy before commenting.            Note:  This article gives the views of the author, and not the position of USAPP – American Politics and Policy, northe London School of Economics.Shortened URL for this post: http://bit.ly/214QLkd _________________________________ About the authorsAlireza Tahbaz-Salehi – Columbia Business SchoolAlireza Tahbaz-Salehi is Daniel W. Stanton Association Professor of Business at ColumbiaBusiness School. His research focuses on the implications of network economies for businesscycle fluctuations and financial stability.  Andrea Vedolin – LSE Department of FinanceAndrea Vedolin is an assistant professor in the Department of Finance  at the London School ofEconomics and Political Science. Her research focuses on theoretical and empirical asset pricing.  Philippe Mueller –  LSE Department of FinancePhilippe Mueller is an assistant professor in the Department of Finance at the London School ofEconomics and Political Science. His research interests are in financial econometrics, empiricalasset pricing and macro-finance.CC BY-NC 3.0 2015 LSE USAPP

Some currency trading positions yield increased returns around Fed announcements

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