Vladyslav Sushko

Financial sector ups and downs and the real sector in the open economy: Up by the stairs, down by the parachute

We examine how financial expansion and contraction cycles affect the broader economy through their impact on real economic sectors in a panel of countries over 1960-2005. Periods of accelerated growth of the financial sector are more likely to be followed by abrupt financial contractions than are periods of slower financial sector growth. Sharp fluctuations in the financial sector have strongly asymmetric effects, with the majority of real sectors adversely affected by contractions, but not helped by expansions. The adverse effects of financial contractions are transmitted almost exclusively through the financial openness channel, with precautionary foreign exchange reserve holdings serving as a key buffer.

The Response of Tail Risk Perceptions to Unconventional Monetary Policy

We evaluate the response of perceived tail risks in financial markets to the implementation of unconventional monetary policy by the U.S. Federal Reserve. Using information from out-of-money equity index options, we find that perceived risks decline significantly in response to both policy announcements and actual asset purchases. The announcement effects are strongest specifically for downside risk measures rather than simple measures of volatility (e.g. the VIX). The impact of actual purchases is strongest when driven by simultaneous expansion and the duration extension of the Federal Reserves balance sheet. These effects of both announcements and purchases have been variable over time and particularly pronounced during the latest policy phases implemented in 2012, a period also coinciding with the Federal Reserves more extensive use of forward guidance about short-term rates.

The Hunt for Duration: Not Waving But Drowning?

Long-term interest rates in Europe fell sharply in 2014 to historically low levels. This development is often attributed to yield-chasing in anticipation of quantitative easing by the European Central Bank. We examine how portfolio adjustments by long-term investors aimed at containing duration mismatches may have acted as an amplification mechanism in this process. Declining long-term interest rates tend to widen the negative duration gap between the assets and liabilities of insurers and pension funds, and any attempted rebalancing by increasing asset duration results in further downward pressure on interest rates. Evidence from the German insurance sector is consistent with such an amplification mechanism.

FX Spot and Swap Market Liquidity and the Effects of Window Dressing

We study the joint evolution of foreign exchange (FX) spot and swap market liquidity. Trading in FX swaps exceeds that of spot, yet this market segment has been largely ignored in prior research on liquidity in FX markets. We find strong co-movement in spot and swap market liquidity conditions and a strong link between FX funding and market liquidity, as gleaned from the pricing of both instruments. This link has strengthened over time with changes in dealer behaviour. Some of the largest dealers periodically pull back from pricing FX swaps and wider spreads attract smaller dealers. At the same time, liquidity in FX swaps remains impaired, which leads to adverse illiquidity spillovers to the spot market. Our findings suggest that funding liquidity has become a more important driver of spot market liquidity than it used to be.This paper assesses liquidity conditions in foreign exchange (FX) spot and derivatives markets using intra-day data against the background of FX dealers’ response to recent regulatory changes. Given that FX swap markets are by some measures even deeper that the spot market, an assessment of FX liquidity requires taking such instruments into account. We find that spot and swap market liquidity is intimately linked. Furthermore, the co-movement between FX funding and market liquidity, as gleaned from the pricing of both types of instruments, has increased over time. This development relates to dealer balance sheet capacity. While top dealers continue to dominate liquidity provision in spot, they tend to pull back from market-making in FX swaps around regulatory reporting periods. This shifts market-making activity in FX derivatives towards smaller, more expensive and less informed, dealers, and also results in adverse spillovers to liquidity conditions in spot markets. JEL classification: F31, G15

The Hunt for Duration: Not Waving but Drowning?

Long-term interest rates in Europe fell sharply in 2014 to historically low levels. This development is often attributed to yield-chasing in anticipation of quantitative easing by the European Central Bank. We examine how portfolio adjustments by long-term investors aimed at containing duration mismatches may have acted as an amplification mechanism in this process. Declining long-term interest rates tend to widen the negative duration gap between the assets and liabilities of insurers and pension funds, and any attempted rebalancing by increasing asset duration results in further downward pressure on interest rates. Evidence from the German insurance sector is consistent with such an amplification mechanism.