Exchange Rates During Financial Crises

Published Date: 02 Nov 2017

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Exchange rates during financial crises

The global financial crisis of 2007-2009 affected the exchange rates movements of all the world’s major currencies. Financial crisis has been viewed as the major challenge that affects the euro as a multinational currency. The other major reason why financial crises has posted major effects on the foreign exchange rates in the large extents to which foreign currencies are tied to the euro and the dollar (Coudert, 2010).

A number of investigations on this subject have given much emphasis to the impacts of the US dollar on how financial crisis affects the exchange rates (McCauley and McGuire, 2009). However, this paper aims at the movements in the exchange rates of a number of emerging foreign exchange markets and small advanced economies in response to financial crisis. In this study, instead the mostly used currencies of the euro and the pound, the Japanese yen, the Swiss franc and the US dollar are used.

This is majorly due to the fact that during the 2007-2009 financial crises, a number of currencies who were not part of the crisis registered a consistent depreciation. This study therefore gives emphasis to two factors that can be used to explain the reason for such depreciation of spectator currencies during the crises. The first aim of the study is to ascertain the reason for the safe haven flows going against the typical crisis related pattern.

During this time, the situation moved out of the countries at the epicenter of the crisis. This goes against the tradition in which such economies are mostly avoided at all cost. The second aim of this study is also to find out why the interest rates differentials played a major role in explaining some of the crisis related exchange movements as compared to the past cases. (Cairn, 2007)

The role of safe haven currencies and the reason for their behavior during financial crisis has major importance to investors. This study therefore provides necessary information that can help investor’s cushion themselves from the effects of financial crisis. As a custom during times of financial crisis, investors tend to turn to a traditional ‘risk off’ investment policies. These include the trading safe haven currencies as opposed to the major currencies like the euro.

Interest rate differential and exchange rate is also another financial issue that this paper looks into. Naturally, capital tends to flow towards the investment choices that post high returns. Interest differential has been shown to have major impacts on capital flows. This is great information to major investors both at the national level and the at the global business sphere. The expectations on exchange rates movement is also another major factor to investors.

Changes in the exchange rates determine the levels of investment returns. This study is therefore of great importance to investors both locally and globally. At times of financial crisis, cushioning investment returns is the major concern to a number of investor. Therefore, the knowledge of the currencies that won’t be affected majorly by these this crisis is highly essential to investors (Gaggnon, 2007).

In this study, a number of methodologies were employed in order to exhaustively reveal some the questions raised. First, the exchange rate movement during the 2008-2009 crises was reviewed in comparison with the Asian financial crisis and the Russian debt default. The measures from currency options, implied volatility and the risk reversals were then analyzed. This is majorly to gauge the risk aversion and market perceptions of uncertainty and the ‘safe haven’ during this period. Based on the previous BIS works, the study then investigated the role of interest rates for exchange rates movements during both the two crisis and their immediate consequences. The methodology used in this study requires good knowledge of data analysis and statistical techniques. This was majorly employed in the calculation of the exchange rate movements during the major financial crisis. These three major financial crises that were statistically evaluated include the global crisis, the Asian and Russian financial crisis.

The paper focuses on two major financial factors that are common across all financial crises in major economies. These are the major areas of concern that affects the movement of exchange rates. First and foremost, the movement of exchange rates are related to the rise and fall in uncertainty and risk aversion. The sharp rises in risk aversion and the unusual exchange rate uncertainty are some of the major issues associated with financial crises. An increase in such a measure was witnessed in the third quarter of the 2008 crisis. A smaller but significant rise of uncertainty and risk aversion was also witnessed in the Russian debt default of 2008.

At times of high uncertainty and risk aversion, the safe haven currencies tend to be more attractive. Safe haven currencies are assets that are viewed to have low risk or high liquidity, an edge asset or a rainy asset (McCauley and McGuire, 2009). During times of financial crises, the period of low risk aversion results mostly into the appreciation of the US dollar. However, at times of high risk aversion, the dollar depreciates as compared to the Japanese yen and the Swiss franc. This is attributed to the status of the Japanese yen and the Swiss franc as safe haven currencies (Ranaldo and Söderlind, 2007).

Allen (2011) attributes the popularity of the Swiss franc currency to its ability to make a comeback immediately after the crisisThis is because major investors galloped away form the major currencies that were strongly hit by the crises. The recognition of a currency as a safe haven currency is depended upon its previous behaviour at times of major financial crisis. The stable, conservative economic and political system of Switzerland is attributed to the establishment of the Swiss franc as a safe haven currency.

The second financial factor that this paper focuses on is the effects of the interest rate differentials and the exchange rate changes. Interest rate differentials have been shown by a number of studies to contribute to the exchange rate patterns at times of financial crises. The study establishes that the exchange rate depreciations and the higher interest rates intensify during times of financial crises. This is attributed to the roles of the carry trades that increase during such times in an economy (Bliss, 2000)

Carry trade is defined as the borrowing or selling of a financial instrument with a low interest rate which is then used to purchase a financial instrument with a higher interest rate. After financial crises, exchange rates and interest differential plays a less consistent role as compared to their depreciation during the time of the crisis.

The data that was used in this study was majorly sourced form previous studies and research papers. The effects of risks aversion, exchange rates and exchange rates were sourced from Bloomberg. This data shows the response of the US dollar, the Japanese yen and the Swiss franc to the effects of financial crises (Galati, 2007)

The data for the exchange rate movement and interest around crisis period for this study was also sourced from Bloomberg, Morgan chase bank, IMF and the BIS calculations. As a result, this study borrows a lot of data form previously conducted survey on the major players of currency stability at times of crisis. There is however need for proper mathematical and financial knowledge for one to be able to make constructive analysis of the data used in this study.

The comparison of the three major crises was also well documented in the literature review of this paper. These include the Asian financial crisis of the 1997-98, the crisis that resulted from the Russian debt default of 2008 and the global financial crisis. The first two crises have been described by analysts as emerging economies crisis. However, the global crisis had its source from the turmoil’s of the US banking system. The Russian and Asian crisis led to the mass rejection of fixed exchange rate regimes at that time. While the Asian and the Russian crisis were confined to Russia and the Asian economies respectively, the global crisis that had its epicentre in the US had global financial ramification. (Beranger, 1999)

The study established that during the 2007-2009 financial crises, a large number of countries that were not at the centre of the crisis had their currencies depreciate against the three currencies on study. However, this depreciation was reversed within a short period after the crisis. This study therefore makes two major conclusions on the behaviour of other currencies during times of financial currencies.

The recent crisis also has a major important deviation from the major two previous crises. In these crises, there was a very quick reversal of the effects of the crisis as compared to the previous episodes. The rebound by the Asian currencies during the Asian crisis was spread to over several years rather than those six months as was seen in this crisis. The ability of the US dollar to fund shortages during this financial crisis to the non-US banking sectors is also another major financial aspect brought to fore by this article.

In times of crisis, capital tends to move from countries that are sharply hit and moves to safe haven currencies. These, the study establishes are the Japanese yen, the Swiss franc and the US dollar. This study hence reveals that the role of short-term interest differential in both depreciation and their reversal has bulged over time. This is majorly due to the increasing role of carry trades in exchange rate movements.

This paper has extensively used research papers that were published mostly during the Russian debt crisis. Most of the cited works are research and peer reviewed journals that majorly talks about the financial crisis. Most of the references are papers published in the BIS quarterly reviewed journals. The other major ratio is academic articles published by major finance departments that highlight the effects of the financial crisis to the major currencies (Neely, 2005)

The journal of finance and the IMF working paper is also the other major contributor of the articles and works cited on this paper. However, the availability of most of these articles is limited to those who have login keys. This therefore makes it technically difficult to access the materials for the purpose of review unless authorized. From the study, it is revealed that during the crisis of 2008, all the major currencies depreciated sharply against the US dollar, the yen and the Swiss franc.

The magnitude and the effects of the depreciation differed as compared with other economies. There is however a major deviation from this result as compared to the previous two episodes of the crisis. The Asian crisis was majorly confined to currencies in that region.

This paper herefore provides a detailed desrcription of the effects of financial crisis on the thrree currencies in question. The US dollar has for long been considered as a safe haven currency due to its ability to withstand economic recessions. As a result, a number of economies experiencing economic turmoil tend to adopt the currency mainly due to its stability. However, studies has shown that there are other currencies with the ability to reamin stable at tough economic times

The political and social set up of Switzerland is attributed by economist to be the reason for its ability to remain stable. This has resulted in the growth of its use globally. As investors tend to adopt safe haven currencies at times of turmioil in the financial sector, the Swiss franc has found soft spot among them. The Japanese yen has also stabled over a period of time and is emerging as one of the favored currencies in global trading