Review: “FX markets’ reactions to

COVID-19: Are they different?”

International Economics Assignment

B.A. (Honors) Business Economics, Semester VI
Submission by: Aarushi Sharma (191501), Muskaan (191519)
Submitted to: Ms. Gunjit Kaur

Paper Reviewed
Walter Bazán-Palomino, Diego Winkelried, June 01, 2021, “FX markets' reactions to
COVID-19: Are they different?”, International Economics
https://www.sciencedirect.com/science/article/pii/S2110701721000378

Abstract
This paper shows the influence of the COVID-19 epidemic on FX markets. During the
epidemic, the USD did not exhibit any safe haven characteristics, in contrast to previous
instances. COVID-19 was also not as risky as past stressful events, according to the
calculated volatility and non-parametric value-at-risk of three currency portfolios. Via this
report, researchers have tried to show that by investing in the Canadian dollar and the
Japanese yen, as well as lowering their exposure to European currencies, investors can
reduce their COVID-19 risk.

Keywords
Currency portfolios, Volatility, Diversification, COVID-19

Abbreviation
FX - Foreign Exchange, VIX Index- Volatility Index, UIP- Uncovered Interest Rate Parity,
DCC- Dynamic Conditional Correlation , GMV- Global Minimum Variance, GARCH -
Generalized AutoRegressive Conditional Heteroskedasticity
Introduction
The paper examines the influence of the COVID 19 pandemic on FX markets empirically,
its implications on market volatility and determining how COVID-19 affected currency
returns and currency portfolios as a result of the pandemic's increased global risk, with an
emphasis on both developed and emerging markets.

COVID-19 differs significantly from prior high-risk occurrences, such as the Global
Financial Crisis, the removal of the Swiss franc/euro floor by the Swiss National Bank, and
Brexit. During the epidemic, the USD did not exhibit any safe haven characteristics, in
contrast to previous instances. COVID-19 was also not as risky as past stressful events,
according to the calculated volatility and non-parametric value-at-risk of three currency
portfolios.

It is pointed out in the paper that during the pandemic breakout in March 2020, the VIX
index achieved a high that was higher than the peak recorded during the Global Financial
Crisis in October 2008, which had a significant negative impact on resource allocation as
well as financial stability. Despite the fact that the global foreign exchange market is the
largest, it has garnered little attention in the report.

To the best of the author's knowledge, the lone exception is Aslam et al. (2020), which
indicates a decline in FX market efficiency during the pandemic. Meanwhile the paper had
contributed using the global minimal variance (GMV) and maximally diversified (MD)
currency portfolio calculations.

The increase in global risk as a result of the pandemic is examined in the paper, with an
emphasis on both established and emerging economies. It assists us in investigating the
responses of European investment funds and banking sectors around the world, as well as
identifying and comparing the reaction of the FX markets to the COVID-19 outbreak to past
high-risk episodes.

Idea behind the issue:

It's crucial to study the concept of ex-ante excess returns on overseas deposits (or bonds) as
well as portfolio creation approaches while moving towards calculation of risk in
developing markets.

The failure of the uncovered interest rate parity (UIP) condition, which states that the
difference in interest rates between two countries is equal to the predicted change in
exchange rates between those countries' currencies, drives gains in the FX markets. It's a
type of interest rate parity (IRP) that's utilised in conjunction with covered interest rate
parity.

Higher interest rates generally boost the value of a country's currency. Higher interest rates
attract foreign investment, raising demand for and the value of the host country's currency.
Lower interest rates, on the other hand, are undesirable to foreign investment and reduce the
currency's relative value.

1. Currency Portfolios
Currency Portfolios are constructed based on the currencies in which foreign assets
are priced and the weights of those assets, which can include equities, bonds, private
market assets, real estate, etc.

For helping in calculating the risk further, Two risk-based portfolio creation strategies
based on minimum-variance and maximum diversification target functions, as well as
a passive investing strategy are taken into consideration.

First is, global minimum variance (GMV) portfolio minimizes portfolio volatility and
consequently resides on the ex-ante efficient frontier's left-most point.

Ex-ante refers to any form of prediction made ahead of time, or before market
participants are aware of the relevant facts. Ex-ante analysis is used in the estimation
of earnings, for example. They consider the expected success of all of a company's
business units, as well as individual goods in some circumstances. This also entails
calculating cash uses like capital investments, dividends, and stock buybacks.
Although none of these outcomes can be predicted with certainty, creating a
prediction establishes a baseline against which reported actuals can be compared.

Here, in this case GMV being on the Ex-Ante efficient frontier helped us in having a
future forecast of the global minimum variance while comparing values of volatility
in the development markets.

The second is the maximally diversified (MD) portfolio, which maximizes the
so-called diversification ratio, which is the ratio of weighted average volatility in
currency returns to portfolio volatility.

Under the assumption that anticipated returns are proportional to volatility,

Choueifaty and Coignard (2008) show that the MD resembles a traditional
 mean-variance portfolio and performs well during periods of turbulence when such
proportionality is more likely to hold.

Furthermore, a passive investment technique is an equally weighted (EW) portfolio,

which provides each currency return in a portfolio the same weight regardless of
correlation structure or individual risk.

Despite its simplicity, the EW can function admirably, particularly during periods of
being non fluctuant.

2. Measuring Covariances
For this approach, the paper followed Ackermann et al. (2017) to improve the
measurement of the covariance matrix of currency returns. Covariance is the measure
of how much the variables vary together. Covariance between exchange rate & return
of a spot position is calculated

3. GARCH
GARCH is a statistical modelling technique that may be used to anticipate the
volatility of financial asset returns. GARCH is suitable for time series data in which
the error term's variance is serially autocorrelated as a result of an autoregressive
moving average process.

4. Dynamic Conditional Correlation (DCC)

The GARCH-DCC involves two steps. The first step accounts for the conditional
heteroskedasticity. It consists in estimating, for each one of the n series of returns and
its conditional volatility. In this case, this model plays a very significant role while
plotting graphs related to volatility in the developing markets.

The dataset in this paper includes daily quotes (against the US dollar) and overnight LIBOR
interest rates for seven markets: Australia, Canada, Switzerland, the Euro Area, Japan, the
United Kingdom, and the United States. Bloomberg's data covers the period from January 3,
2001 through August 24, 2020, yielding 4742 observations per country. Since Australia and
Canada stopped using LIBOR in May 2013, we've been using local overnight rates instead:
RBA Official Cash Rate for Australia and CORRA for Canada.

To detect periods of high volatility, the researchers first build a multivariate FX volatility
index. Then looking at the results of three different currency portfolios. Two of these
portfolios were built with mean-variance optimization, which enables dynamic weights to
swap between long and short positions. They then realized that a static equally weighted
portfolio is the alternative option. The portfolios' performance is measured using volatility,
the Sharpe ratio, and the diversification ratio.

Finally, we see that the researchers compared the performance of these portfolios to the S&P
500 index (a well-known benchmark), since the literature has primarily focused on
carry-trade portfolios, and constructed the global minimum variance (GMV) and maximally
diversified (MD) currency portfolios.

Joining all the Dots

Since 2001, they have identified three additional high-risk events: the Global Financial
Crisis, the Swiss National Bank's (SNB) removal of the CHF/EUR floor, and Brexit.

During the COVID-19 pandemic, the US dollar (USD) weakened. Because of this
weakening, investors have been flocking to currencies other than the US dollar. As a result,
the USD has not acted as a safe haven throughout the COVID-19 pandemic. During the
pandemic, portfolio volatility and return on investment (VaR) are lower than in prior
high-risk events. Furthermore, compared to past high-risk occurrences, both risk indicators
reverted to pre-pandemic levels significantly faster.

Conclusion
COVID-19 pandemic has not created new worries for investors. The COVID-19 pandemic
has had a relatively minor influence on the FX markets and, as a result, on currency returns
and portfolio risk indicators when compared to prior stressful occurrences. This is true
despite the fact that the negative effects on economic activity were projected to be even
worse than they were during the Great Recession. Although it is beyond the scope of this
paper to provide a comprehensive explanation for this finding, one possibility is that market
participants are betting on additional fiscal (unemployment and tax benefits) and monetary
(credit lines, asset purchase programmes, and negative interest rates) stimuli to offset the
impact of COVID-19 on the real economy.

The application of mean-variance portfolio design approaches to currency returns provided

new light on currency portfolio performance. The fact that the MD portfolio has a greater
Sharpe ratio could be exploited by portfolio managers.

Furthermore, we also see while reviewing the report that during a pandemic, investors
should allocate more money to the Japanese yen (JPY) and Canadian dollar (CAD) and less
money to European currencies to reduce risk.