Essays on Exchange Rates and Emerging Markets

This dissertation consists of three essays on exchange rates and international finance with an emphasis on emerging economies. In Chapter 1, I provide empirical evidence that supports the hypothesis that exchange rate based stabilization programs are expansionary during their early phases. I derive a new set of stabilization episodes using extensive country chronologies from Reinhart and Rogoff (2004) and I find that even after controlling for external conditions, the initial expansion associated with the introduction of an exchange rate based program, is caused by both, the program itself and positive external conditions. These expansionary effects are robust to different estimation methods and different criteria for detecting stabilization episodes. In Chapter 2, I study the relationship between foreign interest rates, country spreads, terms of trade and macro fundamentals in emerging markets. I estimate a structural VAR for 15 emerging economies. I find that country spreads explain 12% of output fluctuations, foreign interest rates an additional 7% and the terms of trade about 5%. I also find that country spreads account for a quarter of real exchange rate variability while the terms of trade account for just 1%. To further validate these results, I develop a dynamic stochastic general equilibrium (DSGE) model for a small open economy. The model incorporates several open economy frictions: i) bond-holding adjustment costs, ii) investment adjustment costs, iii) a working capital constraint, and iv) a country spread component that depends upon macro fundamentals, which is taken from the estimated VAR. The model is able to replicate fairly good the propagation effects of foreign rates and country spread shocks but overestimates the importance of the terms of trades. In Chapter 3, I investigate the relation between volatility in the foreign exchange market and excess returns on carry trade portfolios for the G10 currencies. I develop and compare three different investment strategies that aim at avoiding losses when volatility jumps, a common feature of the carry trade. I find that two trading strategies, one based on implied volatility from FX options and the other on exponentially-weighted moving averages, provide better risk-adjusted returns than the standard carry trade. A third strategy, based on Markov-switching exchange rate forecasts, provides excess returns for some currencies but fails for portfolios of currencies. I also show that currency investing provides superior Sharpe ratios than a benchmark bond portfolio and a benchmark stock portfolio, even after including the recent global financial crisis.