Currency Risk Premiums: A Multi-Horizon Perspective

Currency futures-spot basis and risk premium

Currency risk premia and uncovered interest parity in the International CAPM

Currency Risk Premia and Uncovered Interest Parity in the International CAPM

The Role of Currency Risk in Industry Cost of Capital

This dissertation contains three essays dealing with current issues in the foreign exchange and equity exchange markets. The first essay observes that both markets display behaviors akin to momentum and mean reversion. This essay implements a trading strategy combining mean reversion and momentum in foreign exchange markets. The strategy was originally designed for equity markets, but it also generates abnormal returns when applied to uncovered interest parity deviations for five countries. I find that the pattern for the positions thus created in the foreign exchange markets is qualitatively similar to that found in the equity markets. Quantitatively, this strategy performs better in foreign exchange markets than in equity markets. Also, it outperforms traditional foreign exchange trading strategies, such as carry trades and moving average rules.;In the second essay, we further examine the strategy combining mean reversion and momentum in the FX market. Our goal is to find it the abnormal returns thus obtained are compensation for risk. We find a striking similarity between the common stock and FX market returns. We analyze different asset pricing models through a variety of econometrical procedures, such as GMM and two-pass approach. When comparing these models, we assert that the Consumption CAPMs are the only ones that can explain the FX returns.;In the third essay, I look at the zero-investment uncovered interest parity (UIP) portfolio positions as perfect factor-mimicking portfolios for currency risk in the International CAPM context. Their returns are the currency risk premia. Since the UIP positions on average provide low returns, the currency risk premia must be low so that currency risk appears not to be priced in an unconditional model. However, previous research has shown that UIP returns are predictable and may be quite substantial conditionally. I use this observation to generate a specific conditional version of the International CAPM. A GMM approach shows that the conditional model performs well, while the unconditional International CAPM is marginal. The paper thus argues that previous rejections of the International CAPM stem from the fact that currency risk premia are by nature low over extended periods of time and do not provide evidence against the International CAPM.

We propose a novel mechanism to explain the incomplete pass-through of exchange rates to exporter prices and quantities, based on the relationship between exporters' dynamic pricing strategies and currency risk premia. When domestic currency risk premium increases, the relative value of current foreign currency cash flows rises compared to future ones. Consequently, exporters who set prices in customer markets are inclined to increase markups today, leading to higher prices in response to elevated risk premia. This risk-based explanation provides a new perspective on the exchange rate disconnect puzzle, suggesting that a higher currency risk premium dampens the direct impact of exchange rate changes on export prices. We test this mechanism empirically using firm-product level data from Colombian exporters on prices and quantities.

ABSTRACTI uncover an economic source of exposure to global risk that drives international asset prices. Countries that are more central in the global trade network have lower interest rates and currency risk premia. To explain these findings, I present a general equilibrium model in which central countries' consumption growth is more exposed to global consumption growth shocks. This causes the currencies of central countries to appreciate in bad times, resulting in lower interest rates and currency risk premia. Empirically, central countries' consumption growth covaries more with world consumption growth, further validating the proposed mechanism.

An Arbitrage-Free Nelson-Siegel Term Structure Model with Stochastic Volatility for the Determination of Currency Risk Premia

Currency Risk and Capital Accumulation

We review the literature on multi-horizon currency risk premiums.We show how the multihorizon implications arise from the classic present-value relationship.We further show how these implications manifest themselves in the interaction between bond and currency risk premiums.This link is strengthened by explicitly accounting for stochastic discount factors.Information about currency risk premiums at different horizons presents a wealth of new evidence and challenges for existing models.

We use a present-value model of the real exchange rate to impose structure on the currency risk premium. We allow the currency risk premium to depend on both the interest rate differential and a latent component: the missing risk premium. Consistent with the data, our present-value model implies that the real exchange rate should predict currency returns. We find that the missing risk premium, not the interest rate differential, explains most of the variation in the real exchange rate. Moreover, our model sheds light on puzzling relations between the interest rate differential, the real exchange rate, and the currency risk premium.

In this article, we test whether the currency risk premium in the U.S. equity market is particularly higher on prescheduled U.S. macroeconomic announcement days. Our empirical analyses find supporting evidence. Our results help strengthen recent conditional tests on currency risk and suggest that the currency risk premium in the U.S. equity market is driven by U.S. macroeconomic conditions (e.g., U.S. monetary policy).

Standard finite horizon tests uncover only weak evidence of the predictive power of the real exchange rate for excess currency returns. On the other hand, in long-horizon tests, the real exchange rate strongly and negatively predicts future excess currency returns. Conversely, we can attribute most of the variability in real exchange rates to changes in currency risk premiums. The “habit” and “long-run risks” models replicate the predictive power of the real exchange rate for excess currency returns, but substantially overstate the fraction of the volatility of the real exchange rate due to risk premiums. Received December 14, 2017; Editorial decision October 14, 2018 by Editor: Raman Uppal. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

This study analyzes the term structure of interest rates in Mexico.1 Domowitz, Glen and Madhaven (DGM) find that, during the 18 months leading up to the devaluation in December 1994, the term structure was broadly consistent with the expectations hypothesis. In addition, they find that market expectations of default on Mexican securities were fairly stable, and currency risk premia were actually declining immediately preceding the devaluation.KeywordsInterest RateTerm StructureMarket ExpectationExpectation HypothesisDiscriminatory PriceThese keywords were added by machine and not by the authors. This process is experimental and the keywords may be updated as the learning algorithm improves.

Trade Network Centrality and the Currency Carry Trade