Handbook of Exchange Rates

16.1 Introduction

We use the Australian dollar (AUD) as our example. If we think of the factors which impact this currency, we can broadly split them into two categories. Firstly, we have factors specific to the AUD, which are idiosyncratic risks. For example, this can include Australian economic data and the price of commodities which Australia exports such as coal and iron. Secondly, we have factors from the broad market, which we shall term as broad market risk. This can include market expectations for U.S. growth and the state of global equities. The interaction between these two factors drives price action in the AUD.

The CAPM (capital asset pricing model) is a model which attempts to reconcile these two factors (French, 2003). Essentially, the model regresses an asset's returns against the broad market. The constant of this regression is known as alpha. Alpha basically gives an indication of the return which is specific to that asset. The gradient of this regression is known as beta. This gives the sensitivity of that asset to the broad market. If alpha is very low and beta is very high, we conjecture that the asset is highly correlated to the market (a beta of 1 would imply a one-to-one relationship with the market). If the beta of the asset were negative, it would imply that the asset is negatively correlated to the market. Hence, as the market rose, this asset would lose value.

In addition to simply looking at an asset's performance versus the broad market, we can also ...