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The Dynamics of Currency Crashes and Fundamental Reversions

Bjarni Torfason, 2012
Faculty Advisor: Robert Hodrick


This dissertation is composed of three chapters. In Chapter 1 I look at the role of real exchange rates in the asset pricing of currencies. I construct portfolios based on signals about the real exchange rate and analyze the returns of these portfolios as they relate to traditional asset pricing factors and especially how they correlate with carry trade portfolios. Deviations from long term averages of real exchange rates are found to be predictors of crash risk. I also show that there is significant information in real exchange rate signals that does not seem to be priced. In addition to demonstrating this in outright currency markets I provide evidence suggesting that this is also the case in options markets. A relationship between real exchange rates and the VIX volatility over long periods is also demonstrated.

The distribution of returns depends on state variables. For currencies an important variable is the deviations of real exchange rates from their long run means and for stocks the market-to-book ratio serves a similar purpose. Chapter 2 introduces a variant of a mixture of normals that allows for dependence of this kind. The model is estimated using Markov chain Monte Carlo. The results clearly indicate conditionality on the state variables and how high prices of assets predict negative skewness (large losses) for as well as negative returns.

The Icelandic financial collapse, which occurred in the fall of 2008, is without precedent. Never before in modern history has an entire financial system of a developed country collapsed so dramatically. Chapter 3 describes the country's path towards financial liberalization and the economic background that lead to an initially flourishing banking sector. In doing so the paper elaborates on the economic oversights that were made during the financial build-up of the country and how such mistakes contributed to the crash. The focus is thus on identifying the main factors that contributed to the financial collapse and on drawing conclusions about how these missteps could have been avoided. Also summarized are the mistakes that followed in the attempted rescue phase after the disaster had struck. The paper discusses these issues from a general perspective in order to provide an overview of the pitfalls that any fast growing market may be exposed to. The paper concludes that the economic collapse was primarily home-brewed and a consequence of an unbound, risk-seeking banking sector and ineffective (or non-existent) actions of the Icelandic authorities.

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