Financial econometrics-Excess Returns in Emerging-Market Currency Markets: Volatility and Predictability
Excess Returns in Emerging-Market Currency Markets: Volatility and Predictability
You have access to a database NDF & Equity & CDS October 2014.xls on Blackboard, with offshore Non-deliverable forward prices as well as on-shore current spot prices and US and foreign interest rates at 3, 6, and 12-month horizons. You are about to become an emerging market currency trader.
The forward prices are for contracts at three, six and twelve months. You also have the international dollar interest rates and on-shore interest rates for instruments of three, six and twelve month maturities. The data are weekly from 2000. . The data are for China, South Korea, Taiwan, Philippines, Indonesia, and India. We also have on-shore forward rate prices for Singapore, Hong Kong, Thailand and Malaysia.
There is also data on equity prices on the last sheet. You can look at this as well. However the way we compute excess returns in this assignment is special to fixed income or interest-bearing securities.
Mr. Ziyan will update this spreadsheet, but you can work with this, in case there are problems with the Bloomberg or DataStream access to specific series.
Please note that not all of the series have the same time span. The reason is that the NDF data are not publicly available but have to be purchased from Investment banking houses. DataStream, which provides the data, adds to its coverage in a piecemeal fashion.
The excess returns or risk premier are exactly like. For two assets of equal maturity and equal risk in fully integrated markets, there should be no difference, apart from tax considerations, between investing in the 3-month US Treasury or a 3-month Treasury security in the UK denominated in Sterling, with use of the Forward markets for the property maturity.
But of course, investing in emerging market securities is another matter. You will see in the data some real roller coaster rides. At times like this, hedge fund managers ride the surf, making some bit gains but also taking some big losses. This is what their business is about. Even the best surfers hit the sand once in a while.
Remember that the interest rates are reported as percentages in most databases. And all interest rates are reported as annualized interest rates. You do not get 4% after 20 years on a 20-year bond; you will get (1+.04) ˆ20.
So, to make the interest rate series comparable to the forward and spot rate data, you have to convert them to three-month rate holding period returns for comparison to three-month forward rates. How? Simple, use the compounding formula. Let R be the annualized percentage rate. The corresponding 3-month holding period return, in decimal form, is given by the following formula:
R3M = (1 + .01 • R) .25
For a six-month rate, with six-month forward rates, simply do the following, and for the three-month holding return, we raise the annualizedreturn to the power .25:
R6M = (1 + .01 • R) .5
In spreadsheet formulae, if R is in the cell A1 and you wish to convert it to a three-month decimal in cell B1, give the command and enter. Then do the command for the rest of the series in column A.
Do this for the LIBOR3m and the appropriate on-shore rate. Remember to match maturities with the forward rates.
Excess Returns: Covered Interest Parity the excess returns from covered interest parity are easily found.
For the three month forward series and the spot rates, under prefer interest parity, you can put in one dollar in the US and get, after three months,
US return = (1 + .01 ∗ R) .25
You can take the same one dollar, and covert it to Sterling by the Spot rate, S and invest it in overseas, at return R∗ , and convert it back after three months at the spot rate 3 months from now:
Uncovered return = (1 St (1 + .01 ∗ R ∗ ) .25)St+3
This is called un uncovered foreign investment. It is also called carry trade. A lot of this is going on in Japan, with respect to Australia and New Zealand. But of course there is a lot of risk the gains in the foreign UK investment from the interest rate can be wiped out by the changes in the exchange rate.
Investors purchase forward cover: they sell forward their UK returns in the 3-month forward market at time t, at the rate Ft,3 :
This is called un uncovered foreign investment. It is also called carry trad. A lot of this is going on in Japan, with respect to Australia and New Zealand. But of course there is a lot of risk the gains in the foreign UK investment from the interest rate can be wiped out by the changes in the exchange rate.
Investors purchase forward cover: they sell forward their UK returns in the 3-month forward market at time t, at the rate Ft,3 :
Now if the markets are working perfectly and there are no tax considerations, the returns should be the same for the US investment and the covered UK investment. It should not make any difference between putting your money in a US security or a UK security. With the forward cover, there is no currency risk.
Of course there are other types of risks, such as default risk by foreign sovereign governments. So there may be excess returns, even with the purchase of forward cover. In Asia, there are on-shore forward markets for Singapore and Hong Kong but for many countries, particularly China, Korea, Taiwan, Philippines, there are offshore non-deliverable forward markets. There are over-the-counter forward markets in Hong Kong and Singapore, for investors in these countries.
Not, for many countries, the exchange rates for both spot and forward rates reported on the spreadsheet are for the units of local currency per US dollar. So from the perspective of the US investor, we calculate the following formula for the excess returns:
In this case R∗ 3m is the holding period return on a on dollar US investment in the Philippines, for example; R∗ 3m is the return from investing one dollar in the Philippines, for example. The spot rate S is the Philippine Peso/US dollar rate. For converting your dollar to the local currency, in the spot market, use the bid rate. F3M converts your Peso return after three months to US dollars in the Forward market (the Non Deliverable market in Singapore or Hong Kong). For this you use the Ask rate. The excess return is simply the difference between what you get in a foreign investment and a home dollar-denominated investment.
Excess Returns: Uncovered Interest Parity
In the spreadsheet, you can calculate the excess returns in the following way. We have the dates, and the US interest rates for 3, 6, and 12 months, the local interest rates for the same maturity, the NDF (Forward rates), in askbid quotes, for the 3, 6, 12 month forward contracts, and the spot rate for the local currency, with ask and bid quotes. That is all we need to calculate the excess return. Remember that the exchange rates here are the amounts of local currency per US dollar.
For the Philippines, I also have the basis points on one year CDS (credit default swaps). However the CDS market is largest for longer-term bonds, 5 years or more. But in theory the premium on a CDS is the price of risk of default on a bond. The excess return should give similar information.
We have on each country sheet,
Columns B,C, D: the US government security returns for 3,6, and 12 months;
E,F, G: local country returns for 3, 6, 12 months
H,I, J,K, L,M: ask-bid NDF forward rates for maturities of 3, 6, and 12 months,
N,O: ask-bid rate for the spot rate
P: credit default swap premium (in basis points).
OK. How to do excess returns. On the spreadsheet for the Philippine sheet, the one-year excess return is given by: =(1+0.01*G3)*(O3/L3)-(1+0.01*D3)
Match up the columns for the one-year.
Now, for a 3-month holding period excess return: =(1+0.01*E3)*(O3/H3)-(1+0.01*B3)
G3 is the percentage return on a one-year bond, O3 is the bid rate (you get less Pesos), and L3 is the forward asking price (you get less dollars back). D3 is the US annual interest rate.
In the last column I convert the basis point to the decimal for the CDS premia. We can see how they track one another.
Calculate the excess returns or risk premia for other countries at 3 and 6-month maturities.
Then, compare the means, variances, and correlations.
Then examine the linkage with the excess returns: is there any evidence of causality, in the Granger sense, among the countries you select?
Compare and contrast when you do your charts, please put in the dates. You can also do a summary table, with the Granger causality tests.
You will see the roller coaster rises in these currency markets. And learn a lot from this theory when it does not work, when covered interest parity is violated. If you look at Indonesia, for example, you will see big jumps in the excess returns demanded by investors. For sure, a Bali bombing or a Tsunami will do that. So will political instability.
Update1: In NDF_Equity_CDF_Oct2014_2.xls US interest rate has been updated and now has same values across all sheets. Notice that 2001~2007 USGG12M data is missing from Bloomberg.
Update2: In this version currency forward data has been updated. Notice that in some period data is missing from Bloomberg.
Update3: Currency spots are updated.