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Sources of Risk in Currency Returns

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  • Chernov, Mikhail
  • Graveline, Jeremy
  • Zviadadze, Irina

Abstract

We quantify the sources of risk in currency returns as a first step toward understanding the returns reported for the carry trade. 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) Gaussian 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 a jump depreciation (appreciation) in the exchange rate 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. Overall, jumps account for 25% of total currency risk over horizons of one to three months.

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Bibliographic Info

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 8745.

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Date of creation: Jan 2012
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Handle: RePEc:cpr:ceprdp:8745

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Keywords: Bayesian MCMC; carry trades; exchange rates; implied volatility; jumps;

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Cited by:
  1. Andreas Stathopoulos & Andrea Vedolin & Philippe Mueller, 2012. "International Correlation Risk," 2012 Meeting Papers 818, Society for Economic Dynamics.
  2. Huang, Huichou & MacDonald, Ronald & Zhao, Yang, 2012. "Global Currency Misalignments, Crash Sensitivity, and Downside Insurance Costs," MPRA Paper 53745, University Library of Munich, Germany, revised 18 Nov 2013.
  3. Hanno Lustig & Andreas Stathopoulos & Adrien Verdelhan, 2013. "The Term Structure of Currency Carry Trade Risk Premia," NBER Working Papers 19623, National Bureau of Economic Research, Inc.

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