1. Melvin, M., Taylor, M.P. (2009) Marie Alferovičová, Katarína Vinšová, Lucie Wdowyczynová

2. Outline Introduction Pre-Lehman times Post-Lehman times Global Financial Stress Index Conclusion

3. Introduction Financial crisis of 2007 was unparalleled in many respects The paper catalogues shocking events that have occurred Focuses on foreign exchange (FX) market

4. Pre-Lehman times August 2007 „Carry trade“- a strategy of buying, or taking a long position, in high interest rate currencies, funded by selling, or taking a short position, in low interest rate currencies On August 16, 2007 the devastating carry trade unwind occurred (the 1-day change in the JPY price of the AUD was - 7.7% compared to the average daily exchange rate prior to August 16 of only 0.7%)

5. Pre-Lehman times cont. August 2007

6. Main causes of the carry trade unwind in 2007: Heightened volatility (in currency markets and in other assets classes) Deleveraging in currency portfolios Fallen risk appetite and reducing of the size of investors exposures to risky trades, i.e. carry trade

7. Pre-Lehman times November 2007 Main causes of the 2nd stage of the crisis in the FX market: Growth of bank losses due to securities linked to subprime loans „Flight to quality“- away from risky investments and into low-risky investments (e.g. Treasury bills, cash) Fall in commodity prices ⇨ sell-off in commodity currencies (NOK, AUD)

8. Pre-Lehman times March 2008 Clients are moving their businesses away from Bear Stearns because of rumors of firm eminent demise ↓ Short term loan to Bear Stearns from the Federal Reserve Bank of New York ↓ Goldman Sachs informed hedge fund clients that they would assume no further exposure to Bear Stearns ↓ Banks were no longer willing to issue credit protection against Bear’s debt ↓ As Bear was considered „too big to fail“ by FED, market fears were calmed, credit risk receded and JP Morgan Chase bought Bear Stearns

9. Pre-Lehman times cont. March 2008

10. Post-Lehman times September 2008 Summer of 2008 – relative tranquility before a dramatic episode Lehman Brothers Huge losses associated with the subprime mortgage business, dramatic fall of its stock over the year through August Bank of America and Bancleys declined to buy the whole company September 13 – a meeting about Lehman’s future called by the president of New York Fed Not treated as „too big to fail“ (x Bear Stearns) September 15 – bankruptcy announced – a disaster for future development

11. Post-Lehman times cont. September 2008 The aftermath Startling in its dimensions Sharp increase in risk aversion and deleveraging Volatility rose to incredible levels The main problem: credit risk Counterparty risk and liquidity TED spread rose sharply with the news of the Lehman failure (see Figure 3) LIBOR – a price for unsecured interbank lending ⇨ its spread over Treasury bills is a good indicator of the market price of credit risk

12. Post-Lehman times cont. September 2008 Banks hesitant to lend to each other not knowing the details of other balance sheets (many bad assets assumed) Exchange rates – unprecedented levels of volatility, transaction costs also much higher The greater volatility, the greater risk from holding positions ⇨ the bid-ask spread rises to compensate for inventory risk that market makers seek to cover with offsetting trades Fall of 2008 – FX spreads widened dramatically

13. Change in spreads from pre-crisis normal times to the 2008 post-Lehman crisis

14. Change in the number of FX transactions, the average bid-offer spread and the volatility of the spread The hot potato analogy – risk (the hot potato) is passed from institution to institution until it finds a willing home

15. Post-Lehman times cont. September 2008 The high volatility of the spreads = reflection of the thin market trading conditions Counterparty risk Financial institutions monitoring counterparty exposures more carefully than ever Meaning for the FX market: - Managing closely your exposures to different trading partners - Reducing dependence on one bank - Preference for shorter-maturity forwards, futures and options contracts More trades than ever being settled on the CLS system

16. The path of exchange rates (in index values of the price of the U.S. dollar in terms of each of the currencies)

17. Post-Lehman times The aftermath Legislative and regulatory reaction to rein in risk taking and speculative behavior - reducing compensation at banks that have accepted government assistance; FX function treated the same as other areas of the bank in compensation restrictions Large spreads and trading volume in 2008 ⇨ bank profits from FX very large, but bonuses substantially smaller than in past years Dealers expected to charge wider spreads and deal in smaller amounts ⇨ lower risk of the bank, but greater costs on the banks’ clientele Implication for public policy response: lowering liquidity and raising the risks and costs associated with non-bank currency trades Net gain to society from these changes questionable

18. A Global Financial Stress Index FSI – general financial stress index Similar to the index proposed by IMF Differences: not full-sample data (FSI) Similarities: the same examined group (17 countries) Global FSI – an average of individual FSI for each country Characteristics of financial crisis: shifts in asset prices, an increase in risk and uncertainty, shifts in liquidity, decline in banking system health indicators

19. FSI Indicators Banking Sector i. The Beta of banking sector stocks β = Cov 12M (y-o-y Δ% of a country's banking sector equity index & its overall stock market index) / Var 12M (y-o-y Δ% of the overall stock market index) ii. TED spread (btw. interbank rates and the yield on Treasury Bills) = 3M LIBOR (or commercial paper rate) – the government ST rate iii. The slope of the yield curve (or inverted term spread) = gov. ST Treasury Bill yield – gov. LT bond yield

20. FSI Indicators cont. Securities Market i. Corporate bond spreads = corp. bond yield – LT gov. bond yield ii. Stock market returns = monthly Δ% in the country equity market index iii. Time-varying stock return volatility = (exp MA of (deviations from exp MA of national equity market returns) 2 ) 1/2 Foreign Exchange Market i. Time-varying measure of real exchange volatility for each country = (exp MA of (deviations from exp MA of monthly Δ% of real effective exchange rate) 2 ) 1/2

21. FSI calculations National FSI – for each country, equally weighted average of the various components Global FSI – equally weighted average of all national FSI Global FSI series – from December 1983 until October 2008 An extreme value of the FSI – has it been breached? ⇨ Scored FSI = a measure of the how many standard deviations the FSI is away from its time-varying mean(calculated by subtracting off a time-varying mean and dividing through by a time-varying standard deviation)

22. Scored Global Financial Stress Index 1987 – stock market crash; late 1980's – Nikkei/junk bond collapse; 1990 – Scandinavian banking crisis; 1998 – Russian default

23. FSI Deviations Global FSI remains more than one standard deviation above the mean January 2008 and May 2008 – two-standard deviation threshold Lehman Brothers debacle ⇨ more than four standard deviations What does it mean? In August 2007 portfolio could be defended by taking risk off. Probit model of significant drawdown from the carry trade investment as a function of the global FSI (signif. drawdown means >1 s.d. negative return) ⇨ probability of a major drawdown is increasing in the FSI ⇨ statistical significance of the effect of the FSI on the carry trade

24. The economic significance of the FSI effects on carry trade returns A simulation of the returns an investor would earn from investing in Deutsche Bank Carry Return Index Unconditional return (without regard on market conditions) Conditional return – invest in normal periods, close out the position in stressful periods, stress as the Global FSI (FSI > 1 ⇨ exposure is shut off, FSI < 1 ⇨ investment is held) (Information ratio = IR (return per unit of risk)) ⇨ FSI as a risk indicator has potential value to FX investments

25. Caveats regarding this analysis 1) These results ignore transaction costs! FSI signals significant stress → widespread carry trade unwinding → large one-sided market conditions → higher cost of trading Moreover, very thin offers for investors seeking to sell out of their carry positions 2) These results assume the carry trade exposure is eliminated in the same month that the FSI signals stress! A lag btw. recognition of the market stress and exiting the position If investor cannot recognize the shift in real time, it may be too late to reduce carry trade exposure

26. Conclusion The financial crisis – major implications for the FX market August 2007 – subprime-related turmoil – currency market The initial phase: major carry trade sell-off November 2007: credit restrictions ⇨ positions liquidations March 2008: near-failure of Bear Stearns, “too big to fail”, takeover by JP Morgan Chase ⇨ calming the market September 2008: the peak of the crisis, failure of Lehman Brothers ⇨ huge volatility, liquidity disappeared, huge cost of trading currencies Global FSI – dramatic nature of the current crisis, condition the exposure to the carry trade FSI – protecting a portfolio against loss (BUT we have to take into account TC and timely recognition)

27. Thank you for your attention.