The Safe-Haven Effect in Forward Premia: What Makes a Currency Trustworthy?
29 Pages Posted: 28 Aug 2012
Date Written: August 26, 2012
Recently, the role of safe-haven currency has become increasingly remarkable: in the time of stress, uncertainty aversion drives investors to shun the risky currencies and fly for quality. The currency that serves as a safe haven also acts as the benchmark for performance measurement. In this paper we explore what contributes to a safe-haven or benchmark image of currency in turbulence. By comparing floating rates to band-regime ones, strong base currencies to weak ones, and the base currencies with different market shares, we find that the benchmarking role primarily comes from currency' strength measured by interest rate differential. However a low interest rate is not sufficient. A trustworthy currency also has large share in FX markets as well, and in this sense our safe-haven effect is not a pure carry-trade-cycle effect. The exchange-rate regime seems to matter the least. Besides, we find that consistent with the idea that reputation comes from a slow-moving effect, the safe-haven evidence is especially present in the long-run-trend component of the forward premium.
Keywords: forward puzzle, exchange rate regime, base-currency strength, nonstationarity, safe haven
JEL Classification: G15, G32
Suggested Citation: Suggested Citation