Risk Appetite, Carry Trade and Exchange Rates by Liu, Margaritis, and Tourani-Rad - Article Example

Article Review and Analysis Student’s Name: Course Code: Tutor’s Name: Date of Submission: Introduction International finance discipline seeks to establish how the international financial system in terms of their structure, functions and operations affects a country’s economy. In a specific localised context, the study aims at assessing how the international financial system impacts on the Australian economy. Within this context, Liu, Margaritis & Tourani-Rad (2012) sought to establish the nexus between the Yen exchange rate against dominant world currencies such as Australian dollar and measures of risk appetite. The ultimate principal focus of this paper is to summarise and appraise the research by Liu, Margaritis & Tourani-Rad (2012) titled ‘risk appetite, carry trade and exchange rate’. In regard to summary, the paper outlines the purpose, research questions, rationale, literature reviewed, methodology used, analysis & findings. For analysis, the paper critically assesses and reviews if the article offers insightful paradigms and the adequacy of its coverage in relation to pertinent matters. Summary Drawing from the exchange rate data from different countries located in different time zones, the purpose of this research is to assess the link between the Yen exchange rate against other four dominant world currencies such as USD/JPY, GBP/JPY, AUD/JPY & NZD/JPY and measures of risk appetite drawn from indices such as S&P500 index, Dow Jones Industrial Average Index & the VIX index and thus they sought to answer three questions. They sought to establish relationship (long and short run relationship) and asymmetric adjustment in the response of exchange rates by testing if there is any major discrepancy in the exchange rate adjustment reliant on whether the most recent equity prices increased or decreased but also whether exchange rates are on top of or beneath their long-term equilibrium association with the market the index. To justify their choice of Japanese Yen as the benchmark against other currencies, they introduce the context of Yen-carry trade in the currency market. In this regard, they note that in the past 10 years or so, Yen has emerged as the leading investment and trading strategies in the currency market. Within this frame, currency dealers borrow the Yen and trade it for high-yield currencies such as Australian Dollar in the spot FX market. Subsequently the returns realised are invested in fixed income securities such as bills, banks deposit and bond. The rationale for the choice is anchored on the fact that in carry trade yen has been the most popular among investors as a funding currency since for over a decade Japan had the lowest interest rates in the world and thus offered opportunities to investors to exploit high leverage opportunity. To gain prior insight the nexus between the exchange rates of Japanese Yen against some dominant currencies, the study reviewed background information on Yen-carry trade, the Australian dollar (AUD) & New Zealand dollar (NZD). Additionally, they reviewed in a cross comparative manner these two currencies pitted against the Yen. One realisation is that currency market is typical exhibit for speculative trading and that Japanese yen has constantly ranked third as the most widely traded currency across the globe with USD and Euro taking the lead respectively. For AUD & NZD, they note that despite their relatively small economy from comparative basis, AUD was ranked sixth as the highly traded currency by accounting for 6.7% of the average daily turnover while NZD was ranked eleventh with 1.9% average daily turnover in 2009. The other realisation based on the literature is the impact of increased demand on on AUD and NZD. The research established that demand for these currencies creates a ripple effect the value of these currencies goes up and leads to the unwinding of the carry trades and thus subsequently causing currency crash. To answer the problem statement and the three research questions, the study adopted error correction model so as to find out the link between measures of universal risk replaced by US equity market indicators and two-pronged yen exchange rates drawn from S&P 500 index and the implied volatility VIX index. Moreover, since the three equity market indices (universal risk, US equity market and yen exchange rates) are to greater extent correlated especially the two indices (US equity market and yen exchange rates) the study equally employed simple bivariate estimation framework. The three step process was applied to the four countries so as to establish cross rates of each trading day. The research relied on data sampled from four countries. These countries are Australia the United States, New Zealand and United Kingdom. In the process the five currencies were compared against the yen based on equity market variables which included VIX index, S&P500 index and Dow Jones Industrial index. For S&P500 index and Dow Jones Industrial index, the data was limited to January 2, 2003 to December 31, 2009 and sourced from datastream. On the other hand, S&P500 index was sourced CBOE website. Additionally, the FX sampling period in New Zealand and Australia are staggered by one day so to accommodate the difference in time zone. The study found out that that descriptive statistics are nearly similar in all the four samples for all the variables. For instance, it established that the range for NZD/JPY, AUD/JPY and GBP/JPY is much greater than USD/JPY and EUR/ JPY. Secondly, in terms of pair-wise correlation coefficient among the variables, the four samples/ countries exhibit akin correlation coefficients. In terms of relationships, the study found out that long term relationship s is consistent in all the four countries/ samples in different time zones. On the other hand, short-term relationships are different. For instance the response of NZD/JPY, AUD/JPY and GBP/JPY to changes in the US stock market is much greater in the New Zealand and Australian zones than in the UK or US. Moreover, under short-term relationship, the relationship between exchange rates and the equity index is significantly strong while the error correction speed is quite weak. Further, in the response of exchange rates to changes in global risk aversion, the research established existence of asymmetric adjustment. Lastly, it established that there is gradual appreciation of carry trade currencies when conditions are appropriates, but fall drastically when market risks increases. Appraisal The study exhibits a high level of coverage both in terms of structuring and content. The study has introduction, research purpose, research question, literature review, methodology and findings and analysis. The critical aspect in this study is how they manage to link the research purpose with the three research questions so as to establish the link between the Yen exchange rate against other four dominant world currencies such as USD/JPY, GBP/JPY, AUD/JPY & NZD/JPY and measures of risk appetite. Moreover, the methodology and breakdowns given during the analysis easily directs the reader towards the facts and thus enhancing comprehensibility of the research. Despite of all these positive accolades, there are some glaring discrepancies. One weakness that emerges out of this work is the existence of continuity gap in the flow of the study and thus weakening the coverage of pertinent issues. There are missing pieces of information that are outlined in the research problem and equally tackled in the analysis and findings, but are not addressed in the literature review segment. The normative expectation for every study is that the key words in the research problems should be adequately addressed in the subsequent sections of the research thus, meaning even literature review are not excluded. To contextualise and justify this argument, let us revisit the research problem of the study. The research problem is to “assess the link between the Yen exchange rate against other four dominant world currencies such as USD/JPY, GBP/JPY, AUD/JPY & NZD/JPY and measures of risk appetite”. Nevertheless, during the literature review, the study only tackles three elements. These are Yen- carry trade and currency trade in Australia and New Zealand. The discrepancy is that on the research problem/ purpose there are four countries yet only two are tackled. The same trend is exhibited in the analysis and findings sections where the two other countries (UK and US) are again mentioned and discussed in depth yet in the literature they are not covered. The same trend continues in relation to ‘measures of risk appetite’. Measures of risk appetite is mentioned in the research purpose and finalised in the conclusion. Nevertheless, in the literature review, measure of risk appetite is mentioned just briefly in second last paragraph of page 50. The best would have been to examine how risk appetite has been measured. It is a known knowledge that literature review is important in offering insight and empowering researcher to conceptualise and develop theoretical and conceptual framework. Lastly, since international finance aims at establishing implication of international financial systems on a country’s economy, the research didn’t offer recommendations on their findings/ implications. Thus, it beats the logical since in Action Research the basis is to offer solutions to all humanitarian problems be it economic, technological, social or political. Conclusion The aim of this paper was to summarise and review the work by Liu, Margaritis & Tourani-Rad (2012) titled ‘risk appetite, carry trade and exchange rate’. In summarising the research, the paper touched on the purpose, research questions, rationale, literature reviewed, methodology used, analysis & findings. The finding of study found out that consistent long-term relationship existed across the four samples. Nevertheless, for short-term relationship, difference is exhibited across the four samples/ countries. Additionally, it is has been established in the study that asymmetric adjustment exists as means of counteracting changes in exchange rates so as to avoid risks. Lastly, it has been established that there is gradual appreciation of carry trade currencies when conditions are appropriates, but fall drastically when market risks increases. While critically reviewing the research in terms insightfulness and adequacy of coverage, the paper established that the coverage and adequacy of the research is high, but not complete. The rationale is based on the fact that he talks about a sample of four countries in different time zones. But only tackles Australia and New Zealand in their literature review. Equally, they have not addressed the literature on the appetite to invest yet it is part of the research problem. Bibliography Liu, M-H., D. Margaritis, and A. Tourani-Rad (2012), ‘Risk appetite, carry trade and exchange rates’, Global Finance Journal, 23, p. 48-63. Read More