Exchange Rates and Monetary Policy Uncertainty

Abstract

We document that a trading strategy that is short the U.S. dollar and long other currencies exhibits significantly larger excess returns on days with scheduled Federal Open Market Committee (FOMC) announcements. We also show that these excess returns (i) are higher for currencies with higher interest rate differentials vis-à-vis the U.S.; (ii) All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means without the prior permission in writing of the publisher nor be issued to the public or circulated in any form other than that in which it is published.Requests for permission to reproduce any article or part of the Working Paper should be sent to the editor at the above address. AbstractWe document that a trading strategy that is short the U.S. dollar and long other currencies exhibits significantly larger excess returns on days with scheduled Federal Open Market Committee (FOMC) announcements. We also show that these excess returns (i) are higher for currencies with higher interest rate differentials vis-à-vis the U.S.; (ii) increase with uncertainty about monetary policy; and (iii) intensify when the Federal Reserve adopts a policy of monetary easing. We interpret these excess returns as a compensation for monetary policy uncertainty within a parsimonious model of constrained financiers who intermediate global demand for currencies.

US macroannouncements and international asset pricing

“…In addition, we find that US monetary policy announcements are the most important macroeconomic announcements to drive the world market risk premium. Our findings are consistent with the notion of monetary policy uncertainty (Mueller et al, ), and the empirical literature that connects policy uncertainty with systematic risk (e.g., Kelly et al, ). Our results have important theoretical and practical implications.…”

“…Our results have important theoretical and practical implications. In terms of theoretical implications, reinforcing Mueller et al (), our findings suggest that future theoretical models should explicitly take into account the US monetary policy. In terms of practical implications, strengthening Rapach et al (), our findings imply that in capital budgeting, portfolio evaluation, investment, and risk analysis decisions, an international asset‐pricing model that explicitly takes into account the role of the US may be more informative.…”

“…Our finding of the role of the US monetary policy in the global equity market is broadly consistent with the literature that links economic/political announcements with systematic risk. For instance, Mueller et al () find that currency returns are higher on US monetary policy announcement days. Kelly, Pástor, and Veronesi () show that equity options spanning major political events (national elections and global summits) are substantially more expensive than neighbouring options that do not span the event.…”

“…If global investors take more systematic risk on US macroeconomic announcement days (due to US policy uncertainty implied by Mueller, Tahbaz‐Salehi, & Vedolin, ), they should demand higher returns. To test this conjecture, we examine mean excess returns of country ETFs across two types of trading days, namely, US macroeconomic announcement and nonannouncement days.…”

Firm-Level Political Risk: Measurement and Effects*

“…Our efforts relate to several strands of prior literature. An important set of studies documents that risk and uncertainty about shocks emanating from the political system affect asset prices, international capital flows, investment, employment growth, and the business cycle (Belo et al, 2013;Gourio et al, 2015;Handley and Limao, 2015;Kelly et al, 2016;Koijen et al, 2016;Besley and Mueller, 2017;Mueller et al, 2017). In the absence of a direct measure, this literature has relied on identifying variation in aggregate and sector-level political risk using country-level indices, event studies, or the differential exposure of specific sectors to shifts in government contracting.…”