Uncertainty in Financial Markets and the Exchange Risk Premium of the Mexican Peso

Since 2015, the Mexican Peso has been the second most depreciated currency among emerging countries. This depreciation is mostly due to the operating and liquidity conditions of the currency, since it can be traded twenty-four hours a day, seven days a week, which is a relatively uncommon feature among currencies. According to the last triennial survey (2016) of the Bank of International Settlements, the Mexican Peso is the tenth most traded currency across the globe.

In an environment of risk-averse international financial markets, the Mexican Peso is further depreciated because of its use as a proxy for other emerging currencies. In this context of upward pressures on the Mexican Peso, Guillermo Benavides, in his article, “Exchange Rate Risk Premium: An Analysis of its Determinants for the Mexican Peso-USD”, analyzes the determinants of the exchange risk premium (ERP) of the Mexican Peso-US Dollar (USD) exchange rate from 2007–2015 using two econometric models: linear regression and vector autoregression. The exchange risk premium is the amount of additional money an investor demands to be compensated for a depreciation of one currency with respect to another. In this case, the investor holds or plans to hold a long-term position in the currency.

From 2007–2015, the ERP had three peaks as a result of high volatility events in global financial markets. In October 2008, the Mexican Peso depreciated 19 percent during the global financial crisis. In September 2011, the ERP spiked a second time as a result of Greece’s financial crisis. Eventually the ERP decreased, but in May 2013 it increased once again during the Taper Tantrum occurrence, at which time there was an expected reduction in bond purchases by the Federal Reserve.  

The econometric model Benavides uses to determine the drivers of the ERP consists of the following financial variables: the volatility of S&P 500 index options (VIX), a carry trade index, the sovereign bond index of emerging countries calculated by JP Morgan (EMBI), the difference between an interbank and a risk-free interest rate for the USD, and the net investor’s position for the Mexican Peso-USD in the Chicago Mercantile Exchange. The first four indicators are considered proxies of risk. The difference between long and short positions in the future market is a proxy of the Mexican Peso liquidity. The results show that the variables with the highest impact on the ERP are the EMBI and the VIX. Uncertainty in financial markets is the main factor impacting the exchange risk premium of the Mexican Peso-USD, as shown by significant measures of financial volatility and sovereign risk of emerging markets.

The exchange risk premium is a relevant risk indicator that should be taken into account by policymakers such as central banks when they are making decisions about foreign exchange markets. Foreign exchange intervention may have an impact on the currency given the determinants of the exchange risk premium and their specific determinant strength. However, because the Mexican Peso is so heavily influenced by global risk events, domestic exchange rate policy may not have a significant impact on the currency.   

Article source: Benavides, Guillermo. “Exchange Rate Risk Premium: An Analysis of its Determinants for the Mexican Peso-USD.” Banco de Mexico, 2016.

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