The Relationship between Commodity Prices and Currency Exchange Rates [chapter]

Kalok Chan, Yiuman Tse, Michael Williams
Commodity Prices and Markets  
We examine relationships among currency and commodity futures markets based on four commodity-exporting countries' currency futures returns and a range of index-based commodity futures returns. These four commoditylinked currencies are the Australian dollar, Canadian dollar, New Zealand dollar, and South African rand. We fi nd that commodity/currency relationships exist contemporaneously, but fail to exhibit Granger-causality in either direction. We attribute our results to the informational
more » ... iciency of futures markets. That is, information is incorporated into the commodity and currency futures prices rapidly and simultaneously on a daily basis. There are a few studies on the relationship between currency and commodity prices. A recent study by Chen, Rogoff, and Rossi (2008) using quarterly data fi nds that currency exchange rates of commodity-exporting countries have strong forecasting ability for the spot prices of the commodities they export. The authors argue that the currency market is price efficient and can incorporate useful information about future commodity price movements. In contrast, the commodities spot market is far less developed than Kalok Chan is the Synergis-the exchange rate market. Therefore, exchange rates contain forward-looking information beyond what is already refl ected in commodity prices. However, Chen, Rogoff, and Rossi (2008) use commodity prices from either the spot market or the forward market, both of which are less price efficient than the currency spot market. As a result, their evidence cannot be interpreted as absolute superior information processing ability in the currency exchange market over the commodity market. In this chapter, we extend Chen and colleagues by employing futures market data. Relative to the commodity spot market, the futures market offers more convenient, lower cost trading due to its high liquidity, transparent pricing system, high leverage, and allowance of short positions. We, therefore, expect a higher level of informational efficiency for the futures market. Another advantage of studying the futures market is that we can use higher-frequency data. Most previous literature examines commodity/currency relationships using lower-frequency data (e.g., Chen, Rogoff, and Rossi [2008] use quarterly data). This allows the previous literature to examine commodity/currency relationships based on business transactions. Using daily data allows us to examine the fast dynamics between commodity prices and currency rates in terms of the information transmission brought about by informed and speculative transactions. Literature studying commodity/currency relationships began with the Meese-Rogoff Exchange Rate Puzzle, which states that fundamentalsbased currency forecasting models cannot outperform random walk benchmarks (Meese and Rogoff 1983). The puzzle thus suggests that no economic fundamental-to-exchange rate relationship exists. An extensive literature following Meese and Rogoff, however, fi nds contradictions to the Exchange Rate Puzzle (e.and others). Previous studies often cite three explanations for fundamentals-tocurrency relationships in general, and commodity-to-currency relationships in particular. The sticky price model states that commodity price increases lead to infl ationary pressures on a commodity-exporting country's real wages, nontraded goods prices, and exchange rate. However, wages and nontraded goods prices are upwards sticky, leading only commodity price increases to impact the country's exchange rate. The efficient relative price between traded and nontraded goods is then restored by the currency appreciation. The portfolio balance model states that a commodity-exporting country's exchange rate is heavily dependent on foreign-determined asset supply and demand fl uctuations. Thus, commodity price increases lead to a balance of payments surplus and an increase in foreign holdings of the country's currency. Both of these factors, in turn, lead to an increase in the relative demand for the country's currency, leading to positive currency returns (see The Relationship between Commodity Prices and Exchange Rates 49 Chen and Rogoff [2003]; Chen [2004]; and Chen, Rogoff, and Rossi [2008] for further detailed discussions). The third explanation for commodity-to-currency relationships states that commodity price changes proxy exogenous shocks in a commodityexporting country's terms-of-trade (Cashin, Cespedes, and Sahay 2003; Chen and Rogoff 2003) . Terms-of-trade shocks then lead to a shift in the relative demand for an exporter's currency, which, in turn, leads to changes in that exporter's exchange rate (Chen 2004; Chen, Rogoff, and Rossi 2008) . Currency-to-commodity relationships are explained by changes in macroeconomic expectations embedded within currency prices being incorporated into commodity price changes (Mark 1995; Sephton 1992; Gardeazabal, Regulez, and Vasquez 1997; Engel and West 2005; Klaassen 2005) . This is made possible given that exchange rates are forward-looking while commodity prices are based on short-term supply and demand imbalances (Chen, Rogoff, and Rossi 2008) . Under this framework, economic expectations embedded within currency prices contain information regarding a commodity exporter's capacity to meet supply expectations. Thus, expectations regarding future commodity conditions can lead to hedging or hoarding behavior, which, in turn, leads to commodity price changes. Each of the previous models assumes that economic agents adjust their commodity (or currency) holdings based on business activities (i.e., hedging). Additionally, economic agents are capable of capturing incoming commodity/currency information, accurately interpreting that information in light of their business-specifi c conditions, and then acting according to their needs. While these assumptions likely hold over longer periods of time, it is questionable whether they hold for frequencies as low as one day. Our study examines short-horizon commodity/currency relationships using two types of restriction-based causality tests as well as a rolling, outof-sample forecasting methodology. We fi nd no evidence of cross-asset causality or predictive ability in either direction. These results suggest that commodity returns information is rapidly incorporated into currency returns (and vice versa) on a daily level. In light of previous literature, our results also suggest that economic expectations embedded in currency returns are rapidly incorporated into a country's terms-of-trade, which are embedded in commodity returns (and vice versa). We suggest that daily commodity/currency relationships within futures markets are facilitated by relatively informed speculators and these markets' ability to rapidly incorporate information shocks into prices. As a result, commodity/currency lead-lag relationships are not found over daily horizons given that asymmetric information profi ts have already been captured by informed speculators. Many studies provide evidence that the previous explanation is aided by futures markets having an important role in the price discovery process. Specifi cally, futures prices represent unbiased estimates of future spot prices 50
doi:10.7208/chicago/9780226386904.003.0003 fatcat:xplkbacnardynjk7x3jvavfyxe