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Jumps in foreign exchange rates and stochastic unwinding of carry trades

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  • Nirei, Makoto
  • Sushko, Vladyslav

Abstract

Tails in the distribution of JPY/USD exchange rate returns are well approximated by an exponentially dampened power-law. Distribution parameter estimates indicate that yen appreciation jumps belong to a Levy process with unbounded variation, suggesting that same mechanism may be responsible for fluctuations in normal times as well as rare crashes. In contrast, yen depreciation jumps have a well defined second moment suggesting a Gaussian regime. In addition, extreme episodes of yen appreciation are larger and more persistent than episodes of yen depreciation. The asymmetry is magnified and power-law tails are more elongated during times of higher interest rate differential between U.S. and Japan and higher level of VIX indicating that carry trade may be the driver. We propose a model of strategic carry trader behavior that in equilibrium generates exponentially dampened power-law distribution of jumps in foreign exchange along with "up by the stairs down by the elevator" dynamics arising from the assymetries between negative and positive jumps.

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Bibliographic Info

Article provided by Elsevier in its journal International Review of Economics & Finance.

Volume (Year): 20 (2011)
Issue (Month): 1 (January)
Pages: 110-127

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Handle: RePEc:eee:reveco:v:20:y:2011:i:1:p:110-127

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Web page: http://www.elsevier.com/locate/inca/620165

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Keywords: Stochastic games Herd behavior Fat tails Foreign exchange Financial risk and risk management;

References

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Citations

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Cited by:
  1. Bunčák, Tomáš, 2013. "Jump Processes in Exchange Rates Modeling," MPRA Paper 49882, University Library of Munich, Germany.
  2. Taboga, Marco & Pericoli, Marcello, 2008. "Bond risk premia, macroeconomic fundamentals and the exchange rate," MPRA Paper 9523, University Library of Munich, Germany.
  3. Makoto Nirei & Theodoros Stamatiou & Vladyslav Sushko, 2012. "Stochastic Herding in Financial Markets Evidence from Institutional Investor Equity Portfolios," BIS Working Papers 371, Bank for International Settlements.
  4. Kao, Lie-Jane & Wu, Po-Cheng & Lee, Cheng-Few, 2012. "Time-changed GARCH versus the GARJI model for prediction of extreme news events: An empirical study," International Review of Economics & Finance, Elsevier, vol. 21(1), pages 115-129.

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