Project Title: Currency regimes, market microstructure and the currency risk premium
PI: David Chambers (CEAM, CJBS)
Project Period: April 2016 - July 2017
First, we study the currency risk premium over the long-run and the impact of regime changes on the returns to currency speculation. The asset pricing literature has centered on understanding expected return or risk premium. However, the existing literature is lacking a long-run perspective on currency risk and return and on the impact of monetary regime changes. Existing research on currencies typically focuses on the post-Bretton Woods floating period from 1983. Examining the impact of monetary regime shifts on currency returns therefore offers academics and practitioners a new perspective on the risk-return tradeoff in currency speculation.
Second, we study the determinants of bid-ask spreads in the foreign exchange markets. The market microstructure literature argues that bid-ask spread arises due to dealing costs, inventory costs, and adverse selection. However, the literature has struggled to come up with an empirical strategy to identify the three determinants of the bid-ask spread as the measurement requires some inputs that are either non-observable or difficult to quantify. We adopt a novel alternative approach to the estimation of the three components of bid-ask spread in the foreign exchange market, exploiting the implications of exchange rate regimes. For example, in a (credible) fixed regime, bid-ask spreads are solely driven by dealing costs as market makers do not face inventory risk or information asymmetry.