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

Abstract

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

Liu, Fang and Sercu, Piet M. F. A., Why are Some Currencies Viewed as Benchmarks? The Roles of Interest Rates, Economic Size, and Exchange-Rate Regime (February 16, 2009). EFA 2009 Bergen Meetings Paper, Available at SSRN: https://ssrn.com/abstract=1344245 or http://dx.doi.org/10.2139/ssrn.1344245

Fang Liu (Contact Author)

KU Leuven ( email )

Oude Markt 13
Leuven, Vlaams-Brabant 3000
Belgium

Piet M. F. A. Sercu

FEB at KU Leuven ( email )

Naamsestraat 69
Faculty of Economics and Business
Leuven, 3000
Belgium
+32 16 32 67 56 (Phone)
+32 16 32 67 32 (Fax)

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