This is one of the most puzzling puzzles in macroeconomics: that foreign-exchange speculators are not very good at linking domestic money and bond markets to the foreign exchange market. Not enough money seems to be engaged in betting that a currency with a high nominal interest rates will not decline in value fast enough to make investing in its securities unprofitable. Why not? It’s an easy thing to do.
James Hamilton [correction: *Menzie Chinn*] adds more. What are the main hypotheses for why high nominal interest rate currencies appear to outperform the market?
1. The so-called "peso problem." Someday the roof will cave in on these currencies. The Asian financial crisis was only a small disruption compared to what will happen someday. Our current data set is incomplete and does not represent the real population.
2. Holding crummy currencies is riskier than CAPM and variants indicate. Most likely, the relevant investors are not and cannot be well-diversified. So their high pecuniary returns are offset by the risk they bear. If thirty percent of your wealth is in the South African Rand, the relevant measure of your risk may be the variance of that currency, not the covariance of that currency with some broader international market portfolio. Economic theory usually measures risk by looking at the latter.
3. Many investors stay away from crummy, high nominal interest rate currencies for fear of what their wives (or bosses, consider an agency problem at a financial firm) would say, should they lose money. The relevant markets are segmented. This is linked to #2.
4. This used to be a puzzle, but now the profit opportunity has been identified. The supposed additional risk of the high nominal interest rate currency is phantom. People now jump into high nominal interest rate currencies, at least when such investments are appropriate to restore an equilibrium of risks and returns. We should expect the paradox to disappear in future data sets.
Observation: Do not ever write or say "CAPM model." Do not ever write or say "ATM machine."
I don’t think DeLong has a clue. The link is known to every currency
speculator and some do make money. But the foreign currency markets are
fairly “efficient,” although some are more so than others (the market for
the New Zealand dollar is much less deep than the market for the U.S.
dollar). It’s one thing to know the theory, quite another to bet real
money on currency changes.
The head currency trader at the New York office of the Bank of New Zealand
was a client of mine when I was a broker.
He once commented on the connection–and disconnection–between textbook
theory and realtime trading.
If DeLong thinks it’s so easy, why isn’t he running a hedge fund and making
big currency bets?
Or ATM’s ubiquitous sidekick “PIN number”.
I disagree. The objection towards repeating a word from an acronym is merely a shibboleth. “ATM machine,” “PIN number,” and “CAPM model” are quite obviously types of machines, numbers, and models, respectively. That’s the only time that this particular usage is done– the only word ever repeated is the word which describes the general class of which the acronym is a specific type. Certainly it’s odd when you spell out the acronym, but I don’t see the point of objecting to it when the acronym is used.
Also, never say “PIN number”
When I was 9 and I heard Vanilla Ice refer to the VIP Posse, and I knew that VIP stood for Vanilla Ice Posse, that bothered me. I guess I just expected more from Vailla.
What about RBI vs. RBIs for baseball???
Such examples are widely known as “RAS syndrome” (for “redundant acronym syndrome”).
How about “SCUBA gear”? I hardly think using a contextual synonym saves it from the criticism.
I see no reason not to call a machine which operates in Asynchronous Transfer Mode an ATM machine.
Do we also instinctively rule out the occasional “grand slam homerun,” because “grand slam” (in the proper context) implies homerun? When using a different language, is “Takeshima Island” (or “Dokdo Island”) out, since “shima” and “do” both mean island in their original languages?
It seems like Brad was refering to the fact that putting this trade on is easy to execute and seems to make money easily and that people still refuse to do this in large amounts. He probably should have written something like “It’s an easy thing to do. Why aren’t traders doing this?” rather than what he wrote. I think he is genuinely curious as to why they are not doing it, and believes there must be a legitimate reason.
He sees a pile of $100 bills in a room crowded with thieves, cheats and villians, and people are ignoring this pile of bills. Why?
One reason is that the sharpe of this trade would probably be quite low, and the amount of time you have to hold this trade to make it work is far outside the usual parameters of most traders.
In line with reason 1, this is essentially a short options trade. Make decent money 9 out of ten times, lose the farm that 10th time. If you are wrong, you won’t be able to get out until liquidated by your prime broker.
Combine this style of risk with the holding time necessary to make it work and many traders see a career ending trade, not one that makes money.
Random walk beats fundamentals-based forecasting models only at short and medium horizons.
Exchange rates are very wobbly relative to fundamentals: There are studies out there suggesting that the forward rate does as well as professional forecasts.
Mark and Moh argue that UIP works reasonably well except during periods of central bank intervention. They argue that the risk-premium notion doesn’t seem to do a great job explaining things, but then again, our models of risk are non-stellar.
I think Mark has another paper in which he argues that UIP works well but this is difficult to detect in discrete-time data.
If the market is generally populated by chartists, and fundamentalist strategies are only used when the exchange rate is CLEARLY inconsistent with fundamentals, then over short horizons the exchange rate will behave unpredictably — consistent (again) with chartists dominating trading.
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