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.

Risk Preferences and the Macroeconomic Announcement Premium

“…Lucca and Moench (2015) found similar patterns and documented a pre-FOMC announcement drift. Mueller, Tahbaz-Salehi, and Vedolin (2017) documented an FOMC announcement premium on the foreign exchange market and attributed it to compensation to financially constrained intermediaries.…”

External Monetary Constraints Imposed by Developed Economies on Developing Economies: Empirical Evidence from Pakistan

“…Finally, it also provides information regarding relative efficacy, importance, and impact of each monetary transmission channel and thus monetary policy makers can select monetary instrument in a better way to target relatively significant transmission channels (Mishkin, 1995). Moreover, it would be quite difficult for policy makers to ensure financial stability and to mitigate uncertainty regarding the lags and effectiveness of monetary policy in absence of thorough knowledge about monetary transmission (Mueller et al, 2017;Erceg et al, 2018;Kurov and Stan, 2018).…”

The impact of uncertainty on professional exchange rate forecasts

“…Changes in the conditional variances of exogenous processes, such as future policies, potentially affect the risk premium in the foreign exchange market and also introduce volatility in spot rates (Hodrick, 1989). In the aftermath of the crisis, the impact of monetary policy uncertainty on expected and realized spot rates has attracted specific interest from researchers (Mueller et al, 2016;Beckmann and Czudaj, 2016).…”