Exchange Rate Solutions With Currency Crashes

HKIMR Working Paper No.25/2018

42 Pages Posted: 20 Dec 2018

See all articles by Cho-Hoi Hui

Cho-Hoi Hui

Hong Kong Monetary Authority - Research Department

Chi-Fai Lo

The Chinese University of Hong Kong

Chi-Hei Liu

The Chinese University of Hong Kong (CUHK)

Date Written: November 26, 2018

Abstract

We present an exchange rate model in which a currency’s exchange rate is confined in a wide moving band and a currency crash occurs when the rate breaches the lower boundary. A solution is derived from the standard log exchange rate equation for the model with a smooth-pasting condition at the lower boundary. Using an asymmetric mean-reverting fundamental shock, the solution shows the exchange rate follows a mean-reverting square-root process, which is quasi-bounded at the boundary, and generates left-skewed exchange rate distributions consistent with empirical observations. The probability leakage for the exchange rate across the boundary increases with a weakened mean-reverting force for the exchange rate, suggesting an increase in currency crash risk. The empirical results show the exchange rates of nine major currencies against the US dollar can be calibrated according to the model, where the mean reversion is negatively cointegrated with the risk reversals in currency option markets, as expected by the model, and are consistent with the positive relationship between currency crash risk and risk reversals. The leakage condition for breaching the lower boundaries was met during the 2008 global financial crisis when most of the currencies were under the disaster shock.

Keywords: exchange rate dynamics, currency crash, stochastic processes, risk reversals

JEL Classification: F31, G13

Suggested Citation

Hui, Cho-Hoi and Lo, Chi-Fai and Liu, Chi-Hei, Exchange Rate Solutions With Currency Crashes (November 26, 2018). HKIMR Working Paper No.25/2018. Available at SSRN: https://ssrn.com/abstract=3290368 or http://dx.doi.org/10.2139/ssrn.3290368

Cho-Hoi Hui (Contact Author)

Hong Kong Monetary Authority - Research Department ( email )

Hong Kong
China

Chi-Fai Lo

The Chinese University of Hong Kong ( email )

Department of Physics
Shatin, N.T., Hong Kong
China

Chi-Hei Liu

The Chinese University of Hong Kong (CUHK) ( email )

Shatin, N.T.
Hong Kong
Hong Kong

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