Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles

Currency carry trades exploiting violations of uncovered interest rate parity in G10 currencies deliver significant excess returns with annualized Sharpe equal to or greater than those of equity market factors (1990-2012). Using data on out-of-the-money foreign exchange options, I compute returns to crash-hedged portfolios and demonstrate that the high returns to carry trades are not due to peso problems. A comparison of the returns to hedged and unhedged trades indicates crash risk premia account for at most one-third of the excess return to currency carry trades.

/pdf/crash-neutral-currency-carry-trades-4avrn3imub.pdf

Crash-Neutral Currency Carry Trades

I explore the equilibrium value implications of economic models that incorporate responses to a stochastic environment with growth. I propose dynamic valuation decompositions (DVD’s) designed to distinguish components of an underlying economic model that influence values over long investment horizons from components that impact only the short run. A DVD represents the values of stochastically growing claims to consumption payoffs or cash flows using a stochastic discount process that both discounts the future and adjusts for risk. It is enabled by constructing operators indexed by the elapsed time between the trading date and the date of the future realization of the payoff. Thus formulated, methods from applied mathematics permit me to characterize valuation behavior and the term structure of risk prices in a revealing manner. I apply this approach to investigate how investor beliefs and the associated uncertainty are reflected in current-period values and risk-price elasticities.

/pdf/dynamic-valuation-decomposition-within-stochastic-economies-1umijn098r.pdf

Dynamic Valuation Decomposition Within Stochastic Economies

https://www.federalreserve.gov/pubs/ifdp/2012/1068/ifdp1068.pdf

Variance Risk Premiums and the Forward Premium Puzzle

Common Risk Factors in Currency Markets

We quantify the sources of risk in currency returns as a first step toward understanding the returns to currency speculation. To do this, we develop and estimate an empirical model of exchange rate dynamics using daily data for four currencies relative to the US dollar: the Australian dollar, the British pound, the Swiss franc, and the Japanese yen. The model includes (i) normal shocks with stochastic variance, (ii) jumps up and down in the exchange rate, and (iii) jumps in the variance. We identify these components using data on exchange rates and at-the-money implied variances. We nd that the probability of an upward (downward) jump in the exchange rate, associated with depreciation (appreciation) of the US dollar, is increasing in the domestic (foreign) interest rate. The probability of jumps in variance is increasing in the variance but not related to interest rates. Many of the jumps in exchange rates are associated with macroeconomic and political news, but jumps in variance are not. On average, jumps account for 25% (and can be as high as 40%) of total currency risk over horizons of one to three months. Preliminary analysis suggests that properties of currency returns correspond to observed option smiles and that jump risk is priced.

Crash Risk in Currency Returns

We quantify crash risk in currency returns. To accomplish this task, we develop and estimate an empirical model of exchange rate dynamics using daily data for four currencies relative to the US dollar: the Australian dollar, the British pound, the Swiss franc, and the Japanese yen. The model includes (i) normal shocks with stochastic variance, (ii) jumps up and down in the exchange rate, and (iii) jumps in the variance. We identify these components using data on exchange rates and at-the-money implied variances. We nd that crash risk is time-varying. The probability of an upward (downward) jump in the exchange rate, associated with depreciation (appreciation) of the US dollar, is increasing in the domestic (foreign) interest rate. The probability of a jump in variance is increasing in the variance but is not related to interest rates. Many of the jumps in exchange rates are associated with macroeconomic and political news, but jumps in variance are not. On average, jumps account for 25% of total currency risk (and can be as high as 40%), as measured by the entropy of exchange rate changes, over horizons of one to three months. The dollar carry index, which is based on 21 exchange rates, retains these features. A simple calibration analysis using option-implied smiles suggests that jump risk is priced.

/pdf/crash-risk-in-currency-returns-2l67cp2t5g.pdf

We quantify crash risk in currency returns. To accomplish this task, we develop and estimate an empirical model of exchange rate dynamics using daily data for four currencies relative to the US dollar: the Australian dollar, the British pound, the Swiss franc, and the Japanese yen. The model includes (i) normal shocks with stochastic variance, (ii) jumps up and down in the exchange rate, and (iii) jumps in the variance. We identify these components using data on exchange rates and at-the-money implied variances. We find that the probability of an upward (downward) jump in the exchange rate, associated with depreciation (appreciation) of the US dollar, is increasing in the domestic (foreign) interest rate. The probability of jumps in variance is increasing in the variance but not related to interest rates. Many of the jumps in exchange rates are associated with macroeconomic and political news, but jumps in variance are not. On average, jumps account for 25% (and can be as high as 40%) of total currency risk, as measured by the entropy of exchange rate changes, over horizons of one to three months. Preliminary analysis suggests that these properties of currency returns correspond to observed option smiles and that jump risk is priced.

/pdf/crash-risk-in-currency-returns-4x71edmj2q.pdf

I quantify the risk-return relationship in the foreign exchange market in the cross-section and across investment horizons by focusing on the role of multiple sources of US consumption risk. To this end, I estimate a flexible structural model of the joint dynamics of aggregate consumption, inflation, nominal interest rate, and stochastic variance with cross-equation restrictions implied by recursive preferences. I identify the following four structural shocks: inflation, short-run, longrun and variance consumption risks. To measure their relative importance, I compute marginal quantities and prices of risk (marginal Sharpe ratios) in the cross-section of currency baskets for alternative investment horizons. I find that the long-run consumption risk plays a prominent role: it carries an average quarterly Sharpe ratio of 0.28 and contributes to the spread in excess returns between baskets of high and low interest rate currencies across investment horizons from one to five quarters. The short-run consumption risk has an e↵ect on currencies at the horizon of one quarter only, where it explains at least 40% of the corresponding spread in excess returns. The carry trade profitability disappears at horizons longer than four quarters.

/pdf/term-structure-of-consumption-risk-premia-in-the-cross-4dbmvw90q5.pdf

Term Structure of Consumption Risk Premia in the Cross Section of Currency Returns

I quantify the risk-return relationship in the foreign-exchange (FX) market across different countries and investment horizons by focusing on the role of multiple sources of consumption risk. I estimate a flexible structural model of the joint dynamics of US aggregate consumption, inflation, nominal yield, and stochastic variance with cross-equation restrictions implied by recursive preferences. I identify four sources of consumption risk: short-run, long-run, inflation, and variance shocks. The long-run consumption risk plays a prominent role in the FX market: it contributes to the spread in returns between high and low interest rate currencies across multiple investment horizons from one to five quarters. The short-run consumption risk affects currencies only at the quarterly horizon, where it explains 40% of the spread. The difference in returns between high and low yield currencies disappears for horizons longer than four quarters.

/pdf/term-structure-of-consumption-risk-premia-in-the-cross-57lh0h4kpu.pdf

Irina Zviadadze

Papers

Crash Risk in Currency Returns

Crash Risk in Currency Returns

Crash Risk in Currency Returns

Term Structure of Consumption Risk Premia in the Cross Section of Currency Returns

Term-Structure of Consumption Risk Premia in the Cross Section of Currency Returns