Introduction Scapegoat theory and hypotheses Data and empirical methodology Empirical results Conclusions
The Scapegoat Theory of Exchange Rates: The First Tests Marcel Fratzscher* Lucio Sarno** Gabriele Zinna *** * European Central Bank and CEPR ** Cass Business School and CEPR *** Bank of England
June 2011 Fratzscher, Sarno and Zinna
Scapegoat Theory of Exchange Rates
Introduction Scapegoat theory and hypotheses Data and empirical methodology Empirical results Conclusions
Motivation
Exchange rates and scapegoats - practitioners’perspective
"The FX market sometimes seems like a serial monogamist. It concentrates on one issue at a time, but the issue is replaced frequently. ... But uncertainties are being resolved... The market may move back to an earlier love . . . " (FT, November 8 2010) Anecdotal evidence for …nancial markets A literal illustration...
Fratzscher, Sarno and Zinna
Scapegoat Theory of Exchange Rates
Introduction Scapegoat theory and hypotheses Data and empirical methodology Empirical results Conclusions
Fratzscher, Sarno and Zinna
Motivation
Scapegoat Theory of Exchange Rates
Introduction Scapegoat theory and hypotheses Data and empirical methodology Empirical results Conclusions
Motivation
Motivation - academic perspective Time-varying parameters is a key explanation for the failure of exchange rate models (Meese and Rogo¤ 1983, 1988). Instability in the relationship between exchange rates and fundamentals ex post (Rossi 2006, Sarno and Valente 2008, Cheung and Chinn 2001). Scapegoat theory of exchange rates (Bacchetta and van Wincoop 2004, 2011): highly unstable relationship not explained by frequent and large changes in structural parameters, even when allowing for rationality of agents and Bayesian learning... ... but by expectations about these structural parameters. Fratzscher, Sarno and Zinna
Scapegoat Theory of Exchange Rates
Introduction Scapegoat theory and hypotheses Data and empirical methodology Empirical results Conclusions
Motivation
Scapegoat theory of exchange rates Limited knowledge of agents. they have accurate idea about structural parameters in long-term, but signi…cant uncertainty over the short- to medium-term.
If currency movements over the short- to medium-term inconsistent with their priors potentially due to unobservable fundamentals... ...or incorrect weight to fundamentals, rational to search for scapegoat: assign additional weight to some fundamental, usually one that seems out of sync with longer-term equilibrium. Fratzscher, Sarno and Zinna
Scapegoat Theory of Exchange Rates
Introduction Scapegoat theory and hypotheses Data and empirical methodology Empirical results Conclusions
Motivation
Role of scapegoats
Fundamental is more likely to become a scapegoat: the larger the (unexplained) exchange rate movement and the more this particular fundamental seems out of line with its long-run equilibrium.
Fratzscher, Sarno and Zinna
Scapegoat Theory of Exchange Rates
Introduction Scapegoat theory and hypotheses Data and empirical methodology Empirical results Conclusions
Motivation
Approach of paper
Empirical test of scapegoat theory of exchange rates. Novel data on surveys of market participants of exchange rate scapegoats 6 key fundamentals. 12 currencies (advanced and emerging economies). monthly surveys for 9-year period (2001-2009).
Data on FX order ‡ow as proxy for unobservables / liquidity trade matching to scapegoat data.
Fratzscher, Sarno and Zinna
Scapegoat Theory of Exchange Rates
Introduction Scapegoat theory and hypotheses Data and empirical methodology Empirical results Conclusions
Motivation
2 Hypotheses Hypothesis #1: Scapegoat model outperforms benchmark models two benchmarks (constant parameter; time-varying parameter models). strong support along three performance criteria (goodness-of-…t, information, market-timing test). robustness; and for all 12 currencies.
Hypothesis #2: Determinants of scapegoats theory: fundamental becomes scapegoat if size of deviation from equilibrium large and there is sizeable shock to unobservables. empirical: strong and robust evidence, for all currency groups and for all macroeconomic variables. Fratzscher, Sarno and Zinna
Scapegoat Theory of Exchange Rates
Introduction Scapegoat theory and hypotheses Data and empirical methodology Empirical results Conclusions
∆st
=
βt
=
ft ((1
λ) βt + λEt βt ) + (1
Introduction
T
λ ) b t + λ ∑ f t Et β t
i
i =1
Et
+ vt
βt
1
ft
=
(f1,t , f2,t , . . . , fN ,t )0 vector of macro-fundamentals,
βt
=
( β1,t , β2,t , . . . , βN ,t )0 vector of structural params,
Et βt
=
(E t β1,t , E t β2,t , . . . , E t βN ,t )0 vector of expected params,
vt
=
(v1,t , v2,t , . . . , vN ,t )0 vector of i.i.d. shocks to structural params, b t is the unobservable, and λ the discount factor.
. . . so that the impact of ft on ∆st is ∂∆st = (1 ∂ft
T
λ) βt + λEt βt + λ ∑ ft
Fratzscher, Sarno and Zinna
i =0
i
∂Et βt ∂ft
i
Scapegoat Theory of Exchange Rates
1 βt i
Introduction Scapegoat theory and hypotheses Data and empirical methodology Empirical results Conclusions
Introduction
Empirical models Our empirical counterpart to Bacchetta and van-Wincoop is
SCA βt
:
∆st = ft0 βt + (τ t ft )0 γ + δxt + ut
= βt
1
+ vt
where τ t are the surveys (or scapegoat param), xt is the order ‡ow (or unobservable), and E βt = τ t . The two benchmark models are
CP TVP
: ∆st = ft0 β + ut : ∆st = ft0 βt + ut
Fratzscher, Sarno and Zinna
Scapegoat Theory of Exchange Rates
Introduction Scapegoat theory and hypotheses Data and empirical methodology Empirical results Conclusions
Data on scapegoats and fundamentals Data on order ‡ow Econometric methodology
Identifying scapegoats Novel survey data by Consensus Economics 40-60 FX market participants, mostly asset managers, in many di¤erent locations globally, little turnover. relative: "rank the current importance of a range of di¤erent factors in determining exchange rate movements". quantitative: "on a scale from 0 (no in‡uence) to 10 (very strong in‡uence)". 30 currencies vis-a-vis USD (some EUR). six key macro factors relative the reference country: short-term interest rates, long-term interest rates, growth, in‡ation, trade/current account, and equity ‡ows. monthly on broader set of FX surveys, surveys about FX scapegoats every 3 to 6 months. period 2001-2009, focus on 6 advanced country currencies and 6 EME currencies. Fratzscher, Sarno and Zinna
Scapegoat Theory of Exchange Rates
Introduction Scapegoat theory and hypotheses Data and empirical methodology Empirical results Conclusions
Data on scapegoats and fundamentals Data on order ‡ow Econometric methodology
Fundamentals and exchange rate data Match monthly scapegoat data with the actual macroeconomic fundamentals. To obtain monthly data frequency, use trade balance instead of the current account, and use quarterly GDP growth …gures (IMF IFS). Actual macro fundamentals calculated relative to those of reference country. Scaling of scapegoat variables: mean and standard deviation identical to those of actual macro variable. Exchange rate data: nominal bilateral exchange rate, de…ned as foreign price of the domestic currency, change over past month. Fratzscher, Sarno and Zinna
Scapegoat Theory of Exchange Rates
Introduction Scapegoat theory and hypotheses Data and empirical methodology Empirical results Conclusions
Fratzscher, Sarno and Zinna
Data on scapegoats and fundamentals Data on order ‡ow Econometric methodology
Scapegoat Theory of Exchange Rates
Introduction Scapegoat theory and hypotheses Data and empirical methodology Empirical results Conclusions
Data on scapegoats and fundamentals Data on order ‡ow Econometric methodology
Stylised facts about scapegoats CAD/USD
EUR/USD
10
8
10 Growth Rate ST CA
8
6
6
4
4
2 May01
Feb04
Nov06
Aug09
2 May01
Growth Rate ST CA
Feb04
ZAR/USD
Nov06
Aug09
10 Growth Rate LT Equity
8
6
6
4
4
2 May01
Aug09
KRW/USD
10
8
Nov06
Feb04
Nov06
Aug09
Fratzscher, Sarno and Zinna
2 May01
Inflation CA Equity
Feb04
Scapegoat Theory of Exchange Rates
Introduction Scapegoat theory and hypotheses Data and empirical methodology Empirical results Conclusions
Data on scapegoats and fundamentals Data on order ‡ow Econometric methodology
Order ‡ow data Order ‡ow as proxy for unobservable fundamentals scapegoat theory, capture unobservables for two reasons: test whether unobservables exert signi…cant e¤ect on exchange rates control for unobservables in order to test whether scapegoats exert additional e¤ect on exchange rates.
Comprehensive dataset of order ‡ow for all 12 currencies in sample over 2001-10 period. Order ‡ows are bilateral vis-a-vis reference currency; source is UBS Match order ‡ow data to scapegoat data: cumulative monthly order ‡ow on business day previous to latest survey Extension: also order ‡ow from di¤erent types of investors (esp. hedge funds, asset managers). Fratzscher, Sarno and Zinna
Scapegoat Theory of Exchange Rates
Introduction Scapegoat theory and hypotheses Data and empirical methodology Empirical results Conclusions
Data on scapegoats and fundamentals Data on order ‡ow Econometric methodology
For the CP model we simply draw the hyperparameters conditional on the data, assuming an independent inverse Gamma-Normal prior distribution. For TVP and SCA there are two steps. First, we draw a history of states (β) conditional on the hyperparams (Q, δ, γ) and data ([∆s T , f T , x T , τ T ]), using Carter and Kohn (1994) simulation smoother. Then, we draw the hyperparams conditional on the states and data. The priors used in the paper are di¤use, and their distributions are chosen for convenience following a number of papers (Kim and Nelson, 1999; Sargent and Cogley, 2001; Primiceri, 2005). We perform 60,000 replications of which the …rst 40,000 are burned-in, and we save 1 every 10 draws of the last 20,000 replications. Fratzscher, Sarno and Zinna
Scapegoat Theory of Exchange Rates
Introduction Scapegoat theory and hypotheses Data and empirical methodology Empirical results Conclusions
Data on scapegoats and fundamentals Data on order ‡ow Econometric methodology
Selecting macro fundamentals. We use only three fundamentals per regression, as too many params to be estimated in SCA and TVP. But we allow the set of macro fundamentals to be country speci…c, using the following general-to-speci…c method: ∆st = γ1 τ 1,t f1,t + . . . + γ6 τ 6,t f6,t + ut , where we exclude the variable with the lowest t-statistic. We repeat the same procedure until we end up with 3 macro variables. Fratzscher, Sarno and Zinna
Scapegoat Theory of Exchange Rates
Introduction Scapegoat theory and hypotheses Data and empirical methodology Empirical results Conclusions
Scapegoat model estimates In-sample model …t Surveys, Order Flows and Macro Factors
Panel A: Industrialized Economies ∆Growth -
∆In‡ation -
0.1970 [0.01;0.39] -0.4489 [-0.60;-0.29] -0.2919 [-0.46;-0.12] -0.3547 [-0.49;-0.22] -0.0902 [-0.24;-0.06]
-
CZK/EUR
∆Growth -
MXN/USD
-
∆In‡ation -0.0867 [-0.23;0.05] -
AUD/USD CAD/USD EUR/USD JPY/USD CHF/EUR GPB/USD
∆Rate ST 2.5294 [2.04;3.00] 0.1655 [0.01;0.32] -0.1659 [-0.41;0.08] -
-
-
-
0.1142 [-0.09;0.31]
∆Rate LT -0.6406 [-0.92;-0.36] -0.3951 [-0.64;-0.15] -0.1475 [-0.30;0.01] -
CA -0.0560 [-0.18;0.07] -0.2942 [-0.53;-0.05] -0.5189 [-0.95;-0.09] -0.1048 [-0.27;0.06]
∆Equity -0.9626 [-1.28;-0.64] 0.1109 [-0.04;0.27] -
Order Flow -0.0891 [-0.15;-0.02] -0.3812 [ -0.47;-0.29] -0.1743 [-0.54;-0.36] -0.3902 [-0.49;-0.29] -0.1212 [-0.20;-0.04] -0.1393 [-0.22;-0.05]
Panel B: Emerging Market Economies
PLN/EUR
-
ZAR/USD SGD/USD
-0.1445 [-0.36;0.07] -
KRW/USD
-
-0.0660 [-0.27;-0.14] -
∆Rate ST -0.1987 [-0.38;-0.02] 0.0807 [-0.08;0.24] -
-
-
0.0682 [-0.17;0.30]
-
Fratzscher, Sarno and Zinna
∆Rate LT -
CA -
-0.0633 [-0.14;0.02] -0.0297 [-0.22 -0.16] 0.1665 [0.05;0.28] -0.3706 [-0.53;-0.22] -
0.4419 [0.22;0.30] -0.2834 [-0.50;-0.07]
∆Equity 0.6039 [0.60;0.94] -0.1223 [-0.26;0.02] -0.1341 [-0.30;0.03] 0.3672 [0.05;0.68] -0.3447 [-0.55;-0.14] 0.3547 [0.19;0.52]
Scapegoat Theory of Exchange Rates
Order Flow -0.1866 [-0.29;-0.09] -0.1399 [-0.19;-0.01] -0.2207 [-1.53;-1.03] -0.3099 [-0.45;-0.26] -0.3043 [-0.42;-0.19] -0.1901 [-0.28; -0.10]
Introduction Scapegoat theory and hypotheses Data and empirical methodology Empirical results Conclusions
Scapegoat model estimates In-sample model …t Surveys, Order Flows and Macro Factors
Panel A: Industrialized Economies Expl. Variance R2 R 2 adj 7 5 19 16 79 77
Information Criteria log(SSR/T) AIC -0.09 -0.03 -0.35 -0.29 -1.90 -1.75
Market-Timing Tests HR(%) HM 56 0.12(0.10) 66 0.32 (0.08) 87 0.74 (0.06)
AUD/USD
CP TVP SCA
CAD/USD
CP TVP SCA
4 13 35
1 10 30
-0.05 -0.30 -0.59
0.01 -0.25 -0.45
59 65 69
0.18 (0.10) 0.32 (0.09) 0.37 (0.10)
EUR/USD
CP TVP SCA
4 9 49
1 6 46
-0.05 -0.22 -0.90
0.01 -0.16 -0.76
52 66 77
0.04(0.09) 0.32 (0.07) 0.55 (0.08)
JPY/USD
CP TVP SCA
2 3 28
0 0 23
-0.03 -0.12 -0.44
0.03 -0.06 -0.30
50 66 73
0.32 0.45
0(-) (0.09) (0.08)
CHF/EUR
CP TVP SCA
6 9 42
4 7 38
-0.08 -0.21 -0.89
-0.02 -0.15 -0.76
64 65 74
0.28 0.30 0.46
(0.08) (0.08) (0.07)
GBP/USD
CP TVP SCA
4 20 25
1 17 19
-0.05 -0.35 -0.43
0.01 -0.29 -0.11
50 61 68
0.00(0.09) 0.25 (0.08) 0.36 (0.08)
Fratzscher, Sarno and Zinna
Scapegoat Theory of Exchange Rates
Introduction Scapegoat theory and hypotheses Data and empirical methodology Empirical results Conclusions
Scapegoat model estimates In-sample model …t Surveys, Order Flows and Macro Factors
Panel B: Emerging Market Economies Expl. Variance R2 R 2 adj 11 9 16 13 33 28
Information Criterion log(SSR/T) AIC -0.13 -0.07 -0.23 -0.17 -0.40 -0.26
Market-Timing Tests HR(%) HM 56 0.12(0.10) 58 0.16 (0.10) 68 0.35 (0.10)
CZK/EUR
CP TVP SCA
MXN/USD
CP TVP SCA
4 8 11
1 5 4
-0.05 -0.15 -0.17
0.01 -0.09 -0.03
50 55 59
0.01(0.08) 0.08(0.10) 0.16 (0.10)
PLN/EUR
CP TVP SCA
2 16 26
0 14 20
-0.03 -0.29 -0.39
0.03 -0.23 -0.25
52 63 63
0.04(0.09) 0.29 (0.09) 0.27 (0.09)
ZAR/USD
CP TVP SCA
2 8 35
0 6 30
-0.03 -0.19 -0.54
0.03 -0.13 -0.40
56 62 74
0.13(0.11) 0.24 (0.10) 0.48 (0.08)
SGD/USD
CP TVP SCA
3 10 26
0 7 20
-0.04 -0.19 -0.30
0.02 -0.13 -0.15
59 70 74
0.17(0.11) 0.41 (0.08) 0.48 (0.08)
KRW/USD
CP TVP SCA
11 30 52
8 27 49
-0.13 -0.64 -1.10
-0.07 -0.58 -0.96
63 66 77
0.25 0.32 0.55
Fratzscher, Sarno and Zinna
Scapegoat Theory of Exchange Rates
(0.08) (0.10) (0.08)
Introduction Scapegoat theory and hypotheses Data and empirical methodology Empirical results Conclusions
Scapegoat model estimates In-sample model …t Surveys, Order Flows and Macro Factors
Unconditional adj-R2 EMERGING MARKET ECONOMIES 80 CP 70
TVP SCA (no order flow)
60
SCA
50
40
30
20
10
0
-10
1
2
3
4
5
6
CSK
MXN
PLN
ZAR
SGD
KRW
Fratzscher, Sarno and Zinna
Scapegoat Theory of Exchange Rates
Introduction Scapegoat theory and hypotheses Data and empirical methodology Empirical results Conclusions
Scapegoat model estimates In-sample model …t Surveys, Order Flows and Macro Factors
Unconditional adj-R2 INDUSTRIALISED ECONOMIES 80
70
60
50
40
30
20
10
0
-10
1 AUS
2
3
4
5
CAD
EUR
JPY
CHF
Fratzscher, Sarno and Zinna
6 GBP
Scapegoat Theory of Exchange Rates
Introduction Scapegoat theory and hypotheses Data and empirical methodology Empirical results Conclusions
Scapegoat model estimates In-sample model …t Surveys, Order Flows and Macro Factors
Rolling adj-R2 CAD
EUR
100
100
90
90
80
80
70
70
60
60
50
50
40
40
30
30
20
20
10 0
10
Oct02
Feb04
Jul05
Nov06
Apr08
0
Oct02
Feb04
ZAR
Nov06
Apr08
KRW
100
100
90
90
80
80
70
70
60
60
50
50
40
40
30
30
20
20
10 0
Jul05
SCA SCA (no order flow) TVP
10
Oct02
Feb04
Jul05
Nov06
Apr08
Fratzscher, Sarno and Zinna
0
Oct02
Feb04
Jul05
Nov06
Apr08
Scapegoat Theory of Exchange Rates
Introduction Scapegoat theory and hypotheses Data and empirical methodology Empirical results Conclusions
Scapegoat model estimates In-sample model …t Surveys, Order Flows and Macro Factors
When does a fundamental become a scapegoat? τ t,i
I fτ t , >τ i
=
ϕ0 + ϕ1 x t order ‡ow.
xt
=
ft,i
=
g
=
t, i
ft,i Ifτt , >τ g + εt i t, i
macro factor. 1 if survey (τ t,i ) exceeds the two remaining surveys (τ t, i ).
Panel A: All Countries ϕ1 (SE) R 2 adj (%) R 2N adj (%) N
∆Growth 0.44 (0.07)
∆In‡ation 1.12 (0.16)
∆Rate ST 0.47 (0.07)
∆Rate LT 0.40 (0.14)
CA 0.28 (0.10)
∆Equity 0.42 (0.14)
10.2 19.8 199
24.9 37.9 73
11.5 28.2 199
5.0 8.7 264
4.3 8.3 191
2.3 5.1 298
Fratzscher, Sarno and Zinna
Scapegoat Theory of Exchange Rates
Introduction Scapegoat theory and hypotheses Data and empirical methodology Empirical results Conclusions
Scapegoat model estimates In-sample model …t Surveys, Order Flows and Macro Factors
Panel B: Industrialised Economies ϕ1 (SE) R 2 adj (%) R 2N adj (%) N
∆Growth 0.40 (0.06)
∆In‡ation -
∆Rate ST 0.55 (0.09)
∆Rate LT 0.48 (0.15)
CA 0.38 (0.10)
∆Equity 0.76 (0.30)
9.6 19.8 161
-
14.5 32.2 134
7.6 10.9 112
8.2 16.2 131
2.1 2.2 74
Panel C: Emerging Market Economies ϕ1 (SE) R 2 adj (%) R 2N adj (%) N
∆Growth 0.96 (0.18)
∆In‡ation 1.12 (0.16)
∆Rate ST 0.34 (0.08)
∆Rate LT 0.33 (0.20)
CA 0.07 (0.12)
∆Equity 0.39 (0.15)
18.1 23.7 38
24.9 37.8 73
6.7 19.6 65
3.1 5.6 152
0.0 0.0 60
2.5 5.7 224
Fratzscher, Sarno and Zinna
Scapegoat Theory of Exchange Rates
Introduction Scapegoat theory and hypotheses Data and empirical methodology Empirical results Conclusions
Conclusions Present paper is the …rst test of the scapegoat theory of exchange rates (Bacchetta and van Wincoop, 2004, 2011). Test based on novel survey measures of FX scapegoats for 12 currencies, and proprietary order ‡ow data (unobservables), we …nd empirical evidence that strongly supports the empirical implications of the scapegoat theory: The scapegoat model outperforms (in-sample) two benchmark models for a large number of countries and across three performance criteria. Both scapegoats and order ‡ow are important, and their relative contributions vary across countries and time. A macroeconomic fundamental is picked as a scapegoat at times when it shows large movements combined with large changes in the unobservable. Fratzscher, Sarno and Zinna
Scapegoat Theory of Exchange Rates
Introduction Scapegoat theory and hypotheses Data and empirical methodology Empirical results Conclusions
Appendix
Fratzscher, Sarno and Zinna
Scapegoat Theory of Exchange Rates
Introduction Scapegoat theory and hypotheses Data and empirical methodology Empirical results Conclusions
[Additional slides here...]
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Fratzscher, Sarno and Zinna
Scapegoat Theory of Exchange Rates
