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THE CRISIS IN THE FOREIGN EXCHANGE MARKET Michael Melvin* and Mark P. Taylor** March 2009 * Barclays Global Investors, San Francisco **University of Warwick and Barclays Global Investors, London 1. Introduction The global financial crisis of 2007-? is in many respects unparalleled. Compared to the current crisis, recent financial crises such as the 1997 East Asian crisis or the 1998 crisis associated with the collapse of Long Term Capital Management (LTCM) and the Russian bond default had
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    THE CRISIS IN THE FOREIGN EXCHANGE MARKET    Michael Melvin* and Mark P. Taylor**March 2009* Barclays Global Investors, San Francisco**University of Warwick and Barclays Global Investors, London   1 1. Introduction The global financial crisis of 2007-? is in many respects unparalleled. Compared to thecurrent crisis, recent financial crises such as the 1997 East Asian crisis or the 1998 crisisassociated with the collapse of Long Term Capital Management (LTCM) and the Russian bond default had a very much more muted global impact. Of course, these events sentshock waves through global financial markets, but the main damage was fairly contained.It is safe to say that the crisis beginning in 2007 is unlike anything anyone working todayhas ever lived through before. As a result, it is important to chronicle the major eventsthat have unfolded and their implications.In this paper, we focus our attention on the foreign exchange (FX) market. Giventhe relatively low transparency of this market compared to equities and fixed income, it isimportant to draw on knowledge possessed by market “insiders.” There have been manydays of shocking events that have occurred since August 2007 and it is not easy for scholars to appreciate fully the magnitude of the dislocations that have occurred in the FXmarket. We hope successfully to combine our practitioner insights with the discipline of scholars in order to present a useful analysis of what happened and its importance.In Section 2 we provide an overview of the important events of the crisis and their implications for exchange rates and market dynamics; the goal is to catalogue all that wastruly of major importance in this episode. In Section 3 we construct a quantitativemeasure of crises that allows for a comparison of the current crisis to earlier events. Inaddition, we address whether one could have predicted costly events before theyhappened in a manner that would have allowed market participants to moderate their risk    2exposures and yield better returns from currency speculation. In Section 4 we provides asummary and conclusions. 2. Crisis Timeline  The crisis in FX came relatively late. In the early summer of 2007, it was apparent thatfixed income markets were under considerable stress. Then, in July 2007 equity marketsappeared to experience remarkable volatility. In particular, supposedly market-neutralequity portfolios suffered huge losses and it was common to hear people referring to a“five (or larger) standard deviation event”. FX market participants watched these other markets with growing trepidation, wondering when, if and how the market turbulencewould extend to exchange rates. Their fears were met on August 16, 2007: on this date amajor unwinding of the carry trade occurred and many currency market investorssuffered huge losses. As a result, we date the beginning of the crisis in the FX market asAugust 2007. 2.1 August 2007: Contagion from other asset classes and the Carry Trade A very popular strategy for currency investors is the so-called “carry trade.” This is astrategy of buying, or taking a long position, in high-interest rate currencies, funded byselling, or taking a short position, in low-interest rate currencies. For instance, in thesummer of 2007, many currency investors were short Japanese yen (JPY) and longAustralian and New Zealand dollars (AUD and NZD). Interest rate parity (IRP) suggeststhat the interest differential between two currencies should be offset by a change in theexchange rates. A carry trade investor bets that this exchange rate offset will not occur so   3that the interest differential is earned. So while IRP suggests that, with a low interest rateJPY and a high interest rate NZD, one should observe JPY appreciation relative to the NZD. However, there is a large literature indicating that, in fact, it is often the case thatthe low interest rate currency actually depreciates rather than appreciates against the highinterest rate currency. Such an exchange rate movement results in even larger carry trade profits.Carry trades tend to unwind during conditions of market stress and relativelymodest unwinds have been seen historically once or twice a year on average. Prior to2007, the most recent major carry trade unwind was in October 1998 following a Russian bond default and the collapse of Long Term Capital Management. 1 The carry tradeunwind occurring on August 16, 2007 was as devastating for many currency managers aswas the 1998 episode: the one-day change in the JPY price of the AUD on August 16,2007 was -7.7 percent, compare to the average daily change in that exchange rate for 2007 prior to August 15 of only 0.7 percent.Figure 1 displays the returns to the carry trade in 2007 as measured by DeutscheBank’s Carry Index. Deutsche Bank computes the returns to a portfolio that is long thethree highest yielding currencies and short the three lowest yielding currencies across thedeveloped markets. There was a brief period of carry unwind in late-February, early-March associated with an emerging market sell-off that followed a sharp drop in Chineseequity prices. This brief carry unwind was followed by a long run of excellent returns tothe carry trade that peaked on July 25. Throughout early August, carry tradersexperienced a drawdown that culminated in the bloodbath that occurred on August 16.The trough of the return to carry occurred on August 17 and then there was a period of  1 For a description of this episode see Cai, Cheung, Lee, and Melvin (2001).
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