The Crisis in the Foreign Exchange Market

TLDR

The 2007‑2008 financial crisis had major implications for the foreign exchange market. The study reviews events and implications for exchange rates, volatility, currency‑investment returns, and transaction costs, offering a comprehensive blow‑by‑blow narrative for researchers on the crisis’s foreign‑exchange dynamics. The authors develop an implementable financial stress index (FSI) and use it to illustrate the crisis’s severity relative to past crises and to assess its potential to condition carry‑trade exposure and protect portfolios during stress. The FSI demonstrates the crisis’s dramatic nature compared to earlier crises and shows that, despite transaction‑cost and regime‑recognition caveats, it can help protect portfolios from losses during stress.

Abstract

The financial crisis of 2007-2008 had major implications for the foreign exchange market. We review events and implications for exchange rates, volatility, returns to currency investing, and transaction costs. This “blow-by-blow” narrative is intended to be a resource for researchers seeking a comprehensive review of the “what, why and when” of the financial crisis in terms of foreign exchange market dynamics. An implementable financial stress index (FSI) is created and then used to illustrate the dramatic nature of the current crisis compared to earlier crises. We also examine how the global FSI might have been used to condition the exposure to the carry trade (long high interest rate currencies, short low interest rate currencies) and we show that such an index has potential value in protecting a portfolio against loss during periods of stress, although this result is subject to the important caveats of controlling for transaction costs and timely recognition of the change in regime.