The Journal of Finance

Currency Returns, Intrinsic Value, and Institutional‐Investor Flows

Published: 05/03/2005   |   DOI: 10.1111/j.1540-6261.2005.00769.x

KENNETH A. FROOT, TARUN RAMADORAI

We decompose currency returns into (permanent) intrinsic‐value shocks and (transitory) expected‐return shocks. We explore interactions between these shocks, currency returns, and institutional‐investor currency flows. Intrinsic‐value shocks are: dwarfed by expected‐return shocks (yet currency returns overreact to them); unrelated to flows (although expected‐return shocks correlate with flows); and related positively to forecasted cumulated‐interest differentials. These results suggest flows are related to short‐term currency returns, while fundamentals better explain long‐term returns and values. They also rationalize the long‐observed poor performance of exchange‐rate models: by ignoring the distinction between permanent and transitory exchange‐rate changes, prior tests obscure the connection between currencies and fundamentals.

New Hope for the Expectations Hypothesis of the Term Structure of Interest Rates

Published: 06/01/1989   |   DOI: 10.1111/j.1540-6261.1989.tb05058.x

KENNETH A. FROOT

Survey data on interest rate expectations permit separate testing of the two alternative hypotheses in traditional term structure tests: that the expectations hypothesis fails, and that expected future interest rates are ex post inefficient forecasts. We find that the source of the spread's poor predictions of future interest rates varies with maturity. At short maturities the expectations hypothesis fails. At long maturities, however, changes in the yield curve reflect changes in expected future rates one‐for‐one, an implication of the expectations hypothesis. This result confirms earlier findings that long rates underreact to short rates, but now it cannot be attributed to term premia.

Herd on the Street: Informational Inefficiencies in a Market with Short‐Term Speculation

Published: 09/01/1992   |   DOI: 10.1111/j.1540-6261.1992.tb04665.x

KENNETH A. FROOT, DAVID S. SCHARFSTEIN, JEREMY C. STEIN

Standard models of informed speculation suggest that traders try to learn information that others do not have. This result implicitly relies on the assumption that speculators have long horizons, i.e., can hold the asset forever. By contrast, we show that if speculators have short horizons, they may herd on the same information, trying to learn what other informed traders also know. There can be multiple herding equilibria, and herding speculators may even choose to study information that is completely unrelated to fundamentals.

LDC Debt: Forgiveness, Indexation, and Investment Incentives

Published: 12/01/1989   |   DOI: 10.1111/j.1540-6261.1989.tb02656.x

KENNETH A. FROOT, DAVID S. SCHARFSTEIN, JEREMY C. STEIN

We compare different indexation schemes in terms of their ability to facilitate forgiveness and reduce the investment disincentives associated with the large LDC debt overhang. Indexing to an endogenous variable (e.g., a country's output) has a negative moral hazard effect on investment. This problem does not arise when payments are linked to an exogenous variable such as commodity prices. Nonetheless, indexing payments to output may be useful when debtors know more about their willingness to invest than lenders. We also reach new conclusions about the desirability of default penalties under asymmetric information.

Risk Management: Coordinating Corporate Investment and Financing Policies

Published: 12/01/1993   |   DOI: 10.1111/j.1540-6261.1993.tb05123.x

KENNETH A. FROOT, DAVID S. SCHARFSTEIN, JEREMY C. STEIN

This paper develops a general framework for analyzing corporate risk management policies. We begin by observing that if external sources of finance are more costly to corporations than internally generated funds, there will typically be a benefit to hedging: hedging adds value to the extent that it helps ensure that a corporation has sufficient internal funds available to take advantage of attractive investment opportunities. We then argue that this simple observation has wide ranging implications for the design of risk management strategies. We delineate how these strategies should depend on such factors as shocks to investment and financing opportunities. We also discuss exchange rate hedging strategies for multinationals, as well as strategies involving “nonlinear” instruments like options.