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We provide an overview of the important events of the recent global financial crisis and their implications for exchange rates and market dynamics. Our goal is to catalogue all that was truly of major importance in this episode. We also construct a quantitative measure of crises that allows for a comparison of the current crisis to earlier events. In addition, we address whether one could have predicted costly events before they happened in a manner that would have allowed market participants to moderate their risk exposures and yield better returns from currency speculation.

The global financial crisis of 2007–? is in many respects unparalleled. Compared to the current crisis, recent financial crises such as the 1997 East Asian crisis or the 1998 crisis associated with the collapse of Long-Term Capital Management (LTCM) and the Russian bond default had a very much more muted global impact. Of course, these events sent shock waves through global financial markets, but the main damage was fairly contained. It is safe to say that the crisis beginning in 2007 is unlike anything anyone working today has ever lived through before. As a result, it is important to chronicle the major events that have unfolded and their implications. In this paper, we focus our attention on the foreign exchange (FX) market. Given the relatively low transparency of this market compared to equities and fixed income, it is important to draw on knowledge possessed by market “insiders.” There have been many days of shocking events that have occurred since August 2007 and it is not easy for scholars to appreciate fully the magnitude of the dislocations that have occurred in the FX market. We hope successfully to combine our practitioner insights with the discipline of scholars in order to present a useful analysis of what happened and its importance. In Section 2 we provide an overview of the important events of the crisis and their implications for exchange rates and market dynamics; the goal is to catalogue all that was truly of major importance in this episode. In Section 3 we construct a quantitative measure of crises that allows for a comparison of the current crisis to earlier events. In addition, we address whether one could have predicted costly events before they happened in a manner that would have allowed market participants to moderate their risk exposures and yield better returns from currency speculation. In Section 4 we provides a summary and conclusions.

The financial crisis of 2007–? has had major implications for the foreign exchange market. In the earlier part of this paper, we reviewed 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 crisis in the foreign exchange market. The crisis began in August 2007, when subprime-related turmoil in other asset classes finally spilled over into the currency market. This initial phase of the crisis was manifested in a major carry trade sell-off. Then in November 2007, credit restrictions were associated with a major deleveraging in financial markets and many investment funds were forced to liquidate positions. The next major wave of the crisis arrived in March 2008 with the near-failure of Bear Stearns. The treatment of Bear Stearns as “too big to fail” and the orderly takeover by JP Morgan Chase appeared to calm the market so that some semblance of normality returned to financial markets. The peak of the crisis (at least, so far) was the September 2008 failure of Lehman Brothers. By any metric, the crisis in the wake of the Lehman Brothers bankruptcy was unlike anything that had preceded this period: volatility reached unseen levels, liquidity disappeared as counterparty risk reached unprecedented levels so that the cost of trading currencies skyrocketed and it became very difficult to trade any substantial size. In the later part of the paper, we developed a financial stress index (FSI) that is an operationalized, global version of the FSI suggested by the IMF, and we then used the global FSI to illustrate the dramatic nature of the current crisis compared to earlier crises. We also examined 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 showed that such an index has potential value in protecting a portfolio against loss during period of stress, although this result is subject to the important caveats of controlling for transaction costs and timely recognition of the change in regime.