Why are Some Currencies Viewed as Benchmarks? The Roles of Interest Rates, Economic Size, and Exchange-Rate Regime
34 Pages Posted: 16 Feb 2009
Date Written: February 16, 2009
The forward puzzle is traditionally explained as the reflection of a covariance-risk premium, market friction or limits to arbitrage. Recently, Liu and Sercu (2009; henceforth LS), working on intra-ERM rates for the DEM, presented evidence consistent with career-risk considerations (portfolio managers shun assets with danger signals), or with investors otherwise assign fallen-angel status to such assets. In this paper, we test the external validity of this finding: we compare floating rates to band-regime ones, strong base currencies to weak ones, and large economies to small ones. We find that the exchange-rate regime seems to matter the least; but the bench-marking role can come from either a huge economy (the U.S.), a strong currency (Swiss Franc, Dutch Guilder), or good ratings on both counts (Japan and Germany). Consistent with the idea that these are slow-moving reputational effects, the evidence is especially present in the long-run-trend component of the forward premium. In the short-run, filtered part, other factors seem to be at work.
Keywords: forward puzzle, exchange rate regime, base-currency strength, nonstationarity, career-risk premium
JEL Classification: G15, G32
Suggested Citation: Suggested Citation