Document Type

Dissertation

Date of Degree

Spring 2015

Degree Name

PhD (Doctor of Philosophy)

Degree In

Business Administration

First Advisor

Ashish Tiwari

Second Advisor

Paul Weller

Abstract

This thesis consists of three chapters and focuses on the relationship between foreign exchange rates and other areas of Finance. The first chapter is sole-authored and is titled `Foreign Exchange Rate Exposure and Corporate Policies.' The second chapter is coauthored work with Professor Emeritus Paul Weller, Assistant Vice President Chris Neely and Professor David Rapach and is titled `Can Risk Explain the Profitability of Technical Trading in Currency Markets.' The third chapter is titled `Foreign Exchange Movements and Cross-country Fund Allocation Decisions.'

In the first chapter, I examine the relationship between foreign exchange rate exposure and corporate policies. Despite the fact that empirical tests estimate foreign exchange rate exposure net of corporate hedging, there are still firms that exhibit significant residual exposures. It is believed that when faced with higher foreign exchange rate exposure, companies are more likely to run into an underinvestment problem. Therefore, in the current study I explore whether foreign exchange rate exposure is reflected in corporate policies beyond hedging. I establish that companies with higher foreign exchange rate exposure tend to hold more cash, have a higher likelihood of accessing capital markets and are less likely to issue dividends. Further, the relationship between foreign exchange rate exposure and these corporate policies is more pronounced for firms for which the underinvestment problem is likely to be more severe, namely firms with higher growth opportunities and firms operating in more competitive industries. Additionally, I find that half of the significant foreign exchange rate exposures in my sample come from firms with only domestic sales. Thus, I believe that foreign exchange rate exposure is relevant not only to the decisions of multinational corporations with international involvement and deserves additional investigation.

The second chapter examines the robust finding that technical trading rules applied to foreign exchange markets have earned substantial excess returns over long periods of time. However, the approach to risk adjustment has typically been rather cursory, and has tended to focus on the CAPM. We examine the returns to a set of dynamic trading rules and look at the explanatory power of a wide range of models: CAPM, quadratic CAPM, C-CAPM, Carhart's 4-factor model, an extended C-CAPM with durable consumption, Lustig-Verdelhan (LV) factors, volatility and skewness. Although skewness has some modest explanatory power for the observed excess returns, no model can plausibly account for the very strong evidence in favor of the profitability of technical analysis in the foreign exchange market. We conclude that these findings strengthen the case for considering models incorporating cognitive bias and the processes of learning and adaptation, as exemplified in the Adaptive Markets Hypothesis.

The third chapter is motivated by the fact that success of investment in international equity markets is a function of the stock picking ability of the manager within the particular foreign market as well as the (un)favorable foreign exchange rate movements against the domestic currency. Therefore, the objective of this paper is to study in more detail the relationship between currency returns and the cross country equity flows of U.S. international equity mutual funds. We are interested whether mutual funds are able to take advantage of beneficial currency movements and more importantly whether they destroy value through inappropriate currency positions. We establish that funds are better at managing contemporaneous changes in currency movements rather than at predicting future changes. We find that 80% of the funds increase their portfolio exposure to a particular currency (by increasing the relevant country allocation) when it has positive returns and decrease the exposure to that currency when it has negative returns. Further, the average fund does not create or destroy significant value through its country allocation decisions. Moreover, mutual fund managers do not have an advantage in predicting certain currencies over others. Most importantly however, it has to be noted that international mutual funds are not eroding value through their currency management even in the case of the most active funds.

Public Abstract

In this dissertation I explore the connections between foreign exchange markets and risk and other areas of finance. This is an area that has not been explored a lot and can provide interesting insights for academics and practitioners alike.

In the first chapter, I study how companies can manage currency risk beyond the usual hedging. The main finding is that in order to buffer this risk, companies that are highly exposed to foreign exchange movements hold more cash, access external capital markets more often, and issue fewer dividends. Additionally, it is stressed that currency risk is relevant not just for companies with direct international exposure, but also for domestic firms.

In the second chapter, we address the question of what risk factors can explain the high returns earned by technical trading in currency markets. We find that models that are known in the literature to explain the profitability of other currency strategies have little bearing on technical trading, which makes this puzzle even more mysterious.

In the last chapter, we explore whether international equity mutual fund managers are able to take advantage of beneficial currency movements and more importantly whether they destroy value through inappropriate currency positions. We find that managers are better at detecting and responding to contemporaneous currency changes rather than at predicting future currency movements. Most importantly however, we stress that international mutual funds are not eroding value through their currency management even in the case of the most active funds.

Keywords

publicabstract, asset allocation, currency, foreign exchange, mutual funds, risk, technical trading

Pages

xi, 123 pages

Bibliography

Includes bibliographical references (pages 95-96).

Copyright

Copyright 2015 Yuliya Ivanova

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