DOCSLIB.ORG

Crash-Neutral Currency Carry Trades

Total Page：16

File Type：pdf, Size：1020Kb

Download full-text PDF Read full-text

Load more

Crash-Neutral Currency Carry Trades Jakub W. Jurek∗ Abstract Currency carry trades exploiting violations of uncovered interest rate parity in G10 currencies have historically delivered significant excess returns with annualized Sharpe ratios nearly twice that of the U.S. equity market (1990-2008). Using data on foreign exchange options, this paper investigates whether these returns represent compensation for exposure to currency crashes. After eliminating net dollar exposure and hedging crash risk, excess returns to crash-neutral currency carry trades are statistically indistinguishable from zero; returns to non-dollar-neutral portfolios remain positive, but are only weakly significant. The choice of option maturity has a significant impact on the realized excess returns, with quarterly hedging producing annualized returns that are 1-2% higher than those obtained from monthly hedging. First draft: October 2007 This draft: April 2009 ∗Jurek: Princeton University, Bendheim Center for Finance, e-mail: [email protected]. I thank John Campbell, Itamar Drechsler, Steve Edelstein, John Galanek, John Heaton, Mark Mueller, Monika Piazzesi, Erik Stafford, Adrien Verdelhan, and seminar participants at Duke University, Yale University, the Fall 2008 NBER Asset Pricing Meeting, the 2008 Princeton-Cambridge Conference, the 2008 Princeton Implied Volatility Conference, the 2008 Conference on Financial Markets, International Capital Flows and Exchange Rates (European University Institute), the 2009 Oxford- Princeton Workshop on Financial Mathematics and Stochastic Analysis, the Society for Quantitative Analysts and the Harvard Finance Lunch (Fall 2007) for providing valuable comments. I am especially grateful to J.P. Morgan for providing the FX option data. Electronic copy available at: http://ssrn.com/abstract=1262934 Uncovered interest parity predicts that high interest rate currencies should depreciate relative to low interest rate currencies, such that investors would be indifferent between holding the two. Empirically, not only do high interest rate currencies not depreciate relative to their low interest rate counterparts, they tend to appreciate. This finding, often referred to as the forward premium anomaly, is one of the most prominent features of exchange rate data. Historically, the currency carry trade { a strategy designed to exploit this anomaly { has delivered significant excess returns with annualized Sharpe ratios nearly twice that of the U.S. equity market (Figure 1). Using data on foreign exchange options, this paper investigates whether these excess returns reflect compensation for exposure to the risk of large devaluations (crashes) in currencies with high interest rates. I show that after hedging crash risk, returns on portfolios of currency carry trades that are constructed to be dollar-neutral, are statistically indistinguishable from zero (1999-2008). Returns on portfolios that are not constrained to be dollar-neutral are only weakly significant and depend on the choice of portfolio weights (equal- vs. spread-weighted). Finally, I examine the performance of the crash hedge during the credit crisis of 2008, and find significant improvements from using quarterly, rather than monthly, hedging. The currency carry trade exploits the forward premium anomaly by borrowing funds in currencies with low interest rates and lending them in currencies with high interest rates. This strategy captures the interest rate differential (carry) between the two currencies, but leaves the investor exposed to fluctuations in the exchange rate between the high interest rate currency and the low interest rate currency. Historically, since high interest rate currencies have tended to appreciate relative to their low interest rate counterparts, the currency exposure has actually turned out to be an additional source of return. As a result, currency carry trades have been characterized by an extremely attractive risk-return tradeoff. For example, a simple strategy which equal-weighted nine individual carry trades implemented in currency pairs involving the U.S. dollar and one of the remaining G10 currencies earned an annualized excess return of 4:42% with an annualized volatility of 5:05% (Sharpe ratio = 0.88) over the period from January 1990 to December 2007.1 In the latter part of the sample (1999- 2007), simple equal- and spread-weighted portfolios of carry trades delivered even higher Sharpe ratios of 1.06 and 1.35, respectively. To illustrate this, Figure 1 plots the total return indices for the carry strategy vis a vis the total return indices for the three Fama-French risk factors and the momentum portfolio. As can be readily seen from the plot, the returns to the carry strategy dominate the returns to each of the alternatives when the strategies are scaled to have the same ex post volatility. However, the currency carry trade is also exposed to the risk of significant declines, as evidenced by the 20% loss sustained in 2008, driving down the full sample Sharpe ratio to 0.57. The returns to currency carry trades are characterized by two main features. First, the volatility of the strategy is low and stands at roughly one half the volatility of any given X=USD exchange rate, suggesting that exchange rate innovations are largely uncorrelated in the cross-section. Second, 1The set of G10 currencies consists of: Australian dollar (AUD), Canadian dollar (CAD), Swiss franc (CHF), Euro (EUR), British pound (GBP), Japanese yen (JPY), Norwegian krone (NOK), New Zealand dollar (NZD), Swedish krona (SEK), and the U.S. dollar (USD). 1 Electronic copy available at: http://ssrn.com/abstract=1262934 although the low volatility allows the total return index to have an extremely smooth upwards progression, the strategy is punctuated with infrequent, but severe, losses. The skewness of the monthly returns to the equal-weighted carry strategy over the period from January 1990 to December 2008 is negative (-1.62) and its magnitude is nearly twice as large as the skewness of excess returns on the U.S. equity market or the momentum portfolio.2 The very high realized Sharpe ratio of the carry trade and the prominence of negative skewness suggests that the excess returns earned by currency carry trade strategies may represent compensation for exposure to rare, but severe, crashes in currencies with relatively higher interest rates.3 This hypothesis parallels the claims of Barro (2006), Martin (2008) and Weitzman (2007), who argue that crash risk premia play an important role in reconciling estimates of the equity risk premium, and the findings of high volatility and crash risk premia in equity option markets documented by Coval and Shumway (2001), Pan (2002), Bakshi and Kapadia (2003), and Driessen and Maenhout (2006) among others. Of course, the estimated historical mean returns to the currency carry trade may suffer from an upward bias relative to their population counterparts, if the frequency and/or magnitude of crashes in the sample was unusually low (Rietz (1988)). This paper contributes to the literature by investigating whether crash risk premia can account for the empirically observed violations of uncovered interest parity. Under the crash risk hypothesis, excess returns to currencies with relatively higher interest rates represent compensation for exposure to the risk of rapid, large devaluations. In the ensuing analysis, I define crashes as exchange rate shocks that exceed some pre-specified threshold or a multiple of the option-implied volatility. Once exposure to crash risk is hedged, excess returns to currency carry trades are predicted to decline, or be eliminated altogether, if the exposure to currency crashes is the sole risk factor for which investors demand compensation. To investigate the crash risk hypothesis, I adopt two lenses. First, I investigate the time-series properties of the risk-neutral moments (variance, skewness and kurtosis) extracted from foreign exchange options. Since the distributions of currency returns embedded in option prices are forward-looking, they provide a convenient approach for assessing the market's ex ante perceptions regarding the likelihood of crashes, as well as, the cost of insuring against such events. Contrary to the predication of the crash risk hypothesis, I find that risk-neutral skewness does not forecast excess currency returns.4 Nonetheless, the dynamics of risk-neutral skewness exhibit very interesting behavior. In particular, I show that option-implied and realized skewness respond in opposite directions to lagged currency returns, such that the option-implied skewness forecasts 2Brunnermeier, Nagel and Pedersen (2008) argue that realized skewness is related to rapid unwinds of carry trade positions, precipitated by shocks to funding liquidity. Plantin and Shin (2008) provide a game-theoretic motivation of how strategic complementarities, which lead to crowding in carry trades, can generate currency crashes. 3Currency carry trade returns generally appear to be unrelated to risk factors proposed by traditional asset pricing models (Burnside, et. al (2006)), although Lustig and Verdelhan (2007a, 2007b) dispute these findings and argue in favor of a consumption risk factor. Brunnermeier, Gollier, and Parker (2007) argue that high returns of negatively skewed assets may be a general phenomenon. 4Bates (1996) arrives at a similar conclusion for dollar/yen and dollar/mark exchange rates during in the 1984- 1992 sample. Unlike his paper, which relies on a calibrated jump-diffusion model, I use model-free estimates
Recommended publications
  • Seeking Income: Cash Flow Distribution Analysis of S&P 500

    Seeking Income: Cash Flow Distribution Analysis of S&P 500

    RESEARCH Income CONTRIBUTORS Berlinda Liu Seeking Income: Cash Flow Director Global Research & Design Distribution Analysis of S&P [email protected] ® Ryan Poirier, FRM 500 Buy-Write Strategies Senior Analyst Global Research & Design EXECUTIVE SUMMARY [email protected] In recent years, income-seeking market participants have shown increased interest in buy-write strategies that exchange upside potential for upfront option premium. Our empirical study investigated popular buy-write benchmarks, as well as other alternative strategies with varied strike selection, option maturity, and underlying equity instruments, and made the following observations in terms of distribution capabilities. Although the CBOE S&P 500 BuyWrite Index (BXM), the leading buy-write benchmark, writes at-the-money (ATM) monthly options, a market participant may be better off selling out-of-the-money (OTM) options and allowing the equity portfolio to grow. Equity growth serves as another source of distribution if the option premium does not meet the distribution target, and it prevents the equity portfolio from being liquidated too quickly due to cash settlement of the expiring options. Given a predetermined distribution goal, a market participant may consider an option based on its premium rather than its moneyness. This alternative approach tends to generate a more steady income stream, thus reducing trading cost. However, just as with the traditional approach that chooses options by moneyness, a high target premium may suffocate equity growth and result in either less income or quick equity depletion. Compared with monthly standard options, selling quarterly options may reduce the loss from the cash settlement of expiring calls, while selling weekly options could incur more loss.
  • Implied Volatility Modeling

    Implied Volatility Modeling

    Implied Volatility Modeling Sarves Verma, Gunhan Mehmet Ertosun, Wei Wang, Benjamin Ambruster, Kay Giesecke I Introduction Although Black-Scholes formula is very popular among market practitioners, when applied to call and put options, it often reduces to a means of quoting options in terms of another parameter, the implied volatility. Further, the function σ BS TK ),(: ⎯⎯→ σ BS TK ),( t t ………………………………(1) is called the implied volatility surface. Two significant features of the surface is worth mentioning”: a) the non-flat profile of the surface which is often called the ‘smile’or the ‘skew’ suggests that the Black-Scholes formula is inefficient to price options b) the level of implied volatilities changes with time thus deforming it continuously. Since, the black- scholes model fails to model volatility, modeling implied volatility has become an active area of research. At present, volatility is modeled in primarily four different ways which are : a) The stochastic volatility model which assumes a stochastic nature of volatility [1]. The problem with this approach often lies in finding the market price of volatility risk which can’t be observed in the market. b) The deterministic volatility function (DVF) which assumes that volatility is a function of time alone and is completely deterministic [2,3]. This fails because as mentioned before the implied volatility surface changes with time continuously and is unpredictable at a given point of time. Ergo, the lattice model [2] & the Dupire approach [3] often fail[4] c) a factor based approach which assumes that implied volatility can be constructed by forming basis vectors. Further, one can use implied volatility as a mean reverting Ornstein-Ulhenbeck process for estimating implied volatility[5].
  • The JPY/AUD Carry Trade and Its Causal Linkages to Other Markets

    The JPY/AUD Carry Trade and Its Causal Linkages to Other Markets

    The JPY/AUD Carry Trade and Its Causal Linkages to Other Markets Brian D. Deaton McMurry University This study analyzes the causal structure underlying the popular Japanese Yen/Australian Dollar (JPY/AUD) carry trade and related financial variables. Three causal search algorithms are employed to find the relationships amongst the JPY/AUD exchange rate, the S&P 500 stock index, the Nikkei 225 stock index, the Australian Securities Exchange 200 stock index, the 10-year U.S. Treasury Note, the 10- year Japanese government bond, and the 10-year Australian government bond. The results from all three algorithms provide evidence against the theory of uncovered interest rate parity. Keywords: currency carry trade, uncovered interest rate parity, causality, vector autoregression, market linkages INTRODUCTION Long used by hedge funds and institutional investors, currency carry trade investment strategies are now becoming popular with individual investors. Several exchange-traded vehicles, such as the Invesco DB G10 Harvest Fund and the iPath Optimized Currency Carry ETN, have been developed to make it easy for the small investor to participate in carry trade strategies. The popularity of carry trade strategies coupled with ever increasing financial integration between financial markets might lead to spillover effects from currencies to stocks and bonds or vice versa. It is the goal of this paper look for these types of linkages between markets. A currency carry trade is constructed by borrowing money in a currency with low interest rates (funding currency) and simultaneously investing that money in a currency with higher interest rates (target currency) with the goal of profiting on the interest rate differential.
  • Connectedness Between Exchange Rates: How Machine Learning Opens up Fresh Insights Timo Bettendorf and Reinhold Heinlein

    Connectedness Between Exchange Rates: How Machine Learning Opens up Fresh Insights Timo Bettendorf and Reinhold Heinlein

    Research Brief 28th edition – September 2019 Connectedness between exchange rates: how machine learning opens up fresh insights Timo Bettendorf and Reinhold Heinlein Are the exchange rates between certain currencies more What our study shows is that the results of such an estimation closely connected than those of other currencies? Answers depend, in some cases considerably, on how the contempo- to this question can be provided by econometric methods. A raneous relationships between the time series are incorporated. new study shows how machine learning can deliver useful Contemporaneous causal structures, especially, had not been insights into this issue. fully taken on board in earlier studies, which is why in our study previously used procedures led to at times considerably Exchange rates are of major importance for macroeconomic biased results. We solve this problem by using an algorithm developments and are often a topic of political debate. In a for machine learning (see Spirtes et al., 2001). This algorithm recent study (Bettendorf and Heinlein, 2019), we study how uses statistical methods to search for contemporaneous causal bilateral exchange rates between various currencies are con- structures between the variables. These causal structures are nected. We show that the US dollar and, surprisingly, the thus obtained from the data and not, as in other studies, Norwegian krone exert a relatively strong influence on other defined by the user. This means that our study generally models currencies. Such a causal relationship between two currencies contemporaneous causal effects better than previously ap- exists if the pattern of one currency’s exchange rate can be plied procedures.
  • Show Me the Money: Option Moneyness Concentration and Future Stock Returns Kelley Bergsma Assistant Professor of Finance Ohio Un

    Show Me the Money: Option Moneyness Concentration and Future Stock Returns Kelley Bergsma Assistant Professor of Finance Ohio Un

    Show Me the Money: Option Moneyness Concentration and Future Stock Returns Kelley Bergsma Assistant Professor of Finance Ohio University Vivien Csapi Assistant Professor of Finance University of Pecs Dean Diavatopoulos* Assistant Professor of Finance Seattle University Andy Fodor Professor of Finance Ohio University Keywords: option moneyness, implied volatility, open interest, stock returns JEL Classifications: G11, G12, G13 *Communications Author Address: Albers School of Business and Economics Department of Finance 901 12th Avenue Seattle, WA 98122 Phone: 206-265-1929 Email: [email protected] Show Me the Money: Option Moneyness Concentration and Future Stock Returns Abstract Informed traders often use options that are not in-the-money because these options offer higher potential gains for a smaller upfront cost. Since leverage is monotonically related to option moneyness (K/S), it follows that a higher concentration of trading in options of certain moneyness levels indicates more informed trading. Using a measure of stock-level dollar volume weighted average moneyness (AveMoney), we find that stock returns increase with AveMoney, suggesting more trading activity in options with higher leverage is a signal for future stock returns. The economic impact of AveMoney is strongest among stocks with high implied volatility, which reflects greater investor uncertainty and thus higher potential rewards for informed option traders. AveMoney also has greater predictive power as open interest increases. Our results hold at the portfolio level as well as cross-sectionally after controlling for liquidity and risk. When AveMoney is calculated with calls, a portfolio long high AveMoney stocks and short low AveMoney stocks yields a Fama-French five-factor alpha of 12% per year for all stocks and 33% per year using stocks with high implied volatility.
  • Asian Journal of Comparative Law

    Asian Journal of Comparative Law

    Asian Journal of Comparative Law Volume 5, Issue 1 2010 Article 8 Financial Regulation in Hong Kong: Time for a Change Douglas W. Arner, University of Hong Kong Berry F.C. Hsu, University of Hong Kong Antonio M. Da Roza, University of Hong Kong Recommended Citation: Douglas W. Arner, Berry F.C. Hsu, and Antonio M. Da Roza (2010) "Financial Regulation in Hong Kong: Time for a Change," Asian Journal of Comparative Law: Vol. 5 : Iss. 1, Article 8. Available at: http://www.bepress.com/asjcl/vol5/iss1/art8 DOI: 10.2202/1932-0205.1238 ©2010 Berkeley Electronic Press. All rights reserved. Financial Regulation in Hong Kong: Time for a Change Douglas W. Arner, Berry F.C. Hsu, and Antonio M. Da Roza Abstract The global financial system experienced its first systemic crisis since the 1930s in autumn 2008, with the failure of major financial institutions in the United States and Europe and the seizure of global credit markets. Although Hong Kong was not at the epicentre of this crisis, it was nonetheless affected. Following an overview of Hong Kong's existing financial regulatory framework, the article discusses the global financial crisis and its impact in Hong Kong, as well as regulatory responses to date. From this basis, the article discusses recommendations for reforms in Hong Kong to address weaknesses highlighted by the crisis, focusing on issues relating to Lehman Brothers "Minibonds." The article concludes by looking forward, recommending that the crisis be taken not only as the catalyst to resolve existing weaknesses but also to strengthen and enhance Hong Kong's role and competitiveness as China's premier international financial centre.
  • OPTION-BASED EQUITY STRATEGIES Roberto Obregon

    OPTION-BASED EQUITY STRATEGIES Roberto Obregon

    MEKETA INVESTMENT GROUP BOSTON MA CHICAGO IL MIAMI FL PORTLAND OR SAN DIEGO CA LONDON UK OPTION-BASED EQUITY STRATEGIES Roberto Obregon MEKETA INVESTMENT GROUP 100 Lowder Brook Drive, Suite 1100 Westwood, MA 02090 meketagroup.com February 2018 MEKETA INVESTMENT GROUP 100 LOWDER BROOK DRIVE SUITE 1100 WESTWOOD MA 02090 781 471 3500 fax 781 471 3411 www.meketagroup.com MEKETA INVESTMENT GROUP OPTION-BASED EQUITY STRATEGIES ABSTRACT Options are derivatives contracts that provide investors the flexibility of constructing expected payoffs for their investment strategies. Option-based equity strategies incorporate the use of options with long positions in equities to achieve objectives such as drawdown protection and higher income. While the range of strategies available is wide, most strategies can be classified as insurance buying (net long options/volatility) or insurance selling (net short options/volatility). The existence of the Volatility Risk Premium, a market anomaly that causes put options to be overpriced relative to what an efficient pricing model expects, has led to an empirical outperformance of insurance selling strategies relative to insurance buying strategies. This paper explores whether, and to what extent, option-based equity strategies should be considered within the long-only equity investing toolkit, given that equity risk is still the main driver of returns for most of these strategies. It is important to note that while option-based strategies seek to design favorable payoffs, all such strategies involve trade-offs between expected payoffs and cost. BACKGROUND Options are derivatives1 contracts that give the holder the right, but not the obligation, to buy or sell an asset at a given point in time and at a pre-determined price.
  • Currency Order Flow and Real-Time Macroeconomic Information∗

    Currency Order Flow and Real-Time Macroeconomic Information∗

    Currency Order Flow and Real-Time Macroeconomic Information Pasquale DELLA CORTE Dagfinn RIME Imperial College London Norges Bank [email protected] [email protected] Lucio SARNO Ilias TSIAKAS Cass Business School & CEPR University of Guelph [email protected] [email protected] February 2013 Acknowledgements: The authors are indebted for constructive comments to Rui Albuquerque, Philippe Bac- chetta, Ekkehart Boehmer, Nicola Borri, Giuseppe De Arcangelis, Martin Evans, Charles Jones, Nengjiu Ju, Michael King, Robert Kosowski, Michael Moore, Marco Pagano, Alessandro Palandri, Lasse Pedersen, Tarun Ramadorai, Thomas Stolper, Adrien Verdelhan, Paolo Vitale, Kathy Yuan, Sarah Zhang and seminar participants at LUISS Guido Carli University, University of Lugano, Warwick Business School, the 2011 Capital Markets and Corporate Finance Meetings in Kunming, the 2011 Central Bank Workshop on the Microstructure of Financial Markets in Stavanger, the 2011 Conference on Advances in the Analysis of Hedge Fund Strategies in London, the 2011 Workshop on Finan- cial Determinants of Exchange Rates in Rome, the 2012 CFA Society Masterclass Series in London, the 2012 SIRE Econometrics Workshop in Glasgow, the 2012 Rimini Conference in Economics and Finance in Toronto, and the 2012 Northern Finance Association Conference in Niagara Falls. We thank UBS for providing the customer order flow data used in this paper. Sarno acknowledges financial support from the Economic and Social Research Council (No. RES-062-23-2340). Tsiakas acknowledges financial support from the Social Sciences and Humanities Research Council of Canada. The views expressed in this paper are those of the authors, and not necessarily those of Norges Bank.
  • Option Prices Under Bayesian Learning: Implied Volatility Dynamics and Predictive Densities∗

    Option Prices Under Bayesian Learning: Implied Volatility Dynamics and Predictive Densities∗

    Option Prices under Bayesian Learning: Implied Volatility Dynamics and Predictive Densities∗ Massimo Guidolin† Allan Timmermann University of Virginia University of California, San Diego JEL codes: G12, D83. Abstract This paper shows that many of the empirical biases of the Black and Scholes option pricing model can be explained by Bayesian learning effects. In the context of an equilibrium model where dividend news evolve on a binomial lattice with unknown but recursively updated probabilities we derive closed-form pricing formulas for European options. Learning is found to generate asymmetric skews in the implied volatility surface and systematic patterns in the term structure of option prices. Data on S&P 500 index option prices is used to back out the parameters of the underlying learning process and to predict the evolution in the cross-section of option prices. The proposed model leads to lower out-of- sample forecast errors and smaller hedging errors than a variety of alternative option pricing models, including Black-Scholes and a GARCH model. ∗We wish to thank four anonymous referees for their extensive and thoughtful comments that greatly improved the paper. We also thank Alexander David, Jos´e Campa, Bernard Dumas, Wake Epps, Stewart Hodges, Claudio Michelacci, Enrique Sentana and seminar participants at Bocconi University, CEMFI, University of Copenhagen, Econometric Society World Congress in Seattle, August 2000, the North American Summer meetings of the Econometric Society in College Park, June 2001, the European Finance Association meetings in Barcelona, August 2001, Federal Reserve Bank of St. Louis, INSEAD, McGill, UCSD, Universit´edeMontreal,andUniversity of Virginia for discussions and helpful comments.
  • Monte Carlo Strategies in Option Pricing for Sabr Model

    Monte Carlo Strategies in Option Pricing for Sabr Model

    MONTE CARLO STRATEGIES IN OPTION PRICING FOR SABR MODEL Leicheng Yin A dissertation submitted to the faculty of the University of North Carolina at Chapel Hill in partial fulfillment of the requirements for the degree of Doctor of Philosophy in the Department of Statistics and Operations Research. Chapel Hill 2015 Approved by: Chuanshu Ji Vidyadhar Kulkarni Nilay Argon Kai Zhang Serhan Ziya c 2015 Leicheng Yin ALL RIGHTS RESERVED ii ABSTRACT LEICHENG YIN: MONTE CARLO STRATEGIES IN OPTION PRICING FOR SABR MODEL (Under the direction of Chuanshu Ji) Option pricing problems have always been a hot topic in mathematical finance. The SABR model is a stochastic volatility model, which attempts to capture the volatility smile in derivatives markets. To price options under SABR model, there are analytical and probability approaches. The probability approach i.e. the Monte Carlo method suffers from computation inefficiency due to high dimensional state spaces. In this work, we adopt the probability approach for pricing options under the SABR model. The novelty of our contribution lies in reducing the dimensionality of Monte Carlo simulation from the high dimensional state space (time series of the underlying asset) to the 2-D or 3-D random vectors (certain summary statistics of the volatility path). iii To Mom and Dad iv ACKNOWLEDGEMENTS First, I would like to thank my advisor, Professor Chuanshu Ji, who gave me great instruction and advice on my research. As my mentor and friend, Chuanshu also offered me generous help to my career and provided me with great advice about life. Studying from and working with him was a precious experience to me.
  • Foreign Exchange Markets and Exchange Rates

    Foreign Exchange Markets and Exchange Rates

    Salvatore c14.tex V2 - 10/18/2012 1:15 P.M. Page 423 Foreign Exchange Markets chapter and Exchange Rates LEARNING GOALS: After reading this chapter, you should be able to: • Understand the meaning and functions of the foreign exchange market • Know what the spot, forward, cross, and effective exchange rates are • Understand the meaning of foreign exchange risks, hedging, speculation, and interest arbitrage 14.1 Introduction The foreign exchange market is the market in which individuals, firms, and banks buy and sell foreign currencies or foreign exchange. The foreign exchange market for any currency—say, the U.S. dollar—is comprised of all the locations (such as London, Paris, Zurich, Frankfurt, Singapore, Hong Kong, Tokyo, and New York) where dollars are bought and sold for other currencies. These different monetary centers are connected electronically and are in constant contact with one another, thus forming a single international foreign exchange market. Section 14.2 examines the functions of foreign exchange markets. Section 14.3 defines foreign exchange rates and arbitrage, and examines the relationship between the exchange rate and the nation’s balance of payments. Section 14.4 defines spot and forward rates and discusses foreign exchange swaps, futures, and options. Section 14.5 then deals with foreign exchange risks, hedging, and spec- ulation. Section 14.6 examines uncovered and covered interest arbitrage, as well as the efficiency of the foreign exchange market. Finally, Section 14.7 deals with the Eurocurrency, Eurobond, and Euronote markets. In the appendix, we derive the formula for the precise calculation of the covered interest arbitrage margin.
  • Time-Varying Global Dollar Risk in Currency Markets

    Time-Varying Global Dollar Risk in Currency Markets

    Time-Varying Global Dollar Risk in Currency Markets Ingomar Krohn∗ JOB MARKET PAPER Link to the latest version November 20, 2019 ABSTRACT This paper documents that the price of dollar risk exhibits significant time variation, switching sign after large realized dollar fluctuations, when global dollar demand is high and funding constraints are tight. To exploit this feature of dollar risk, I propose a novel currency investment strategy which is effectively short the dollar in normal states, but long the dollar after large dollar movements. The proposed strategy is not exposed to standard risk factors, yields an annualized return exceeding 4%, and has an annualized Sharpe ratio of 0.34, significantly higher than that of well-known currency strategies. Furthermore, I show that currencies other than the dollar do not exhibit the same sign-switching pattern in their price of risk, consistent with the view that the dollar is special. Keywords: foreign-exchange, U.S. dollar, systematic FX risk, trading strategies, currency betas, FX options, derivative markets. This Version: November 2019. ∗Copenhagen Business School, Solbjerg Pl. 3, 2000 Frederiksberg, DK, Email: [email protected] 1 I. Introduction Conventional wisdom places a special role to the U.S. economy and to its currency in international financial and foreign exchange (FX) markets.1 Indeed, the U.S. dollar is on one side of over 88% of all foreign exchange transactions, it is the dominant invoicing currency, and it is the numeraire of the world's largest equity market.2 However, the literature disagrees on whether the dollar is a unique currency in the sense that it is a risk factor driving risk premia in the cross-section of all other currencies.