Global Currency Misalignments, Crash Sensitivity, and Downside Insurance Costs

We show that the profitability of currency carry trades can be understood as the compensation for exchange rate misalignment risk based on the rare disastrous model of exchange rates (Farhi and Gabaix, 2008). It explains over 97% of the cross-sectional excess returns and dominates other candidate factors, including volatility and liquidity risk. Both currency carry and misalignment portfolios trade on the position-likelihood indicator (Huang and MacDonald, 2013) that explores the probability of the Uncovered Interest Rate Parity (UIP) to hold in the option pricing model. To examine the crash story of currency risk premia, we employ copula method to capture the tail sensitivity (CS) of currencies to the global market, and compute the moment risk premia by model-free approach using volatility risk premia as the proxy for downside insurance costs (DI). We find: (i) notable time-varying currency risk premia in pre-crisis and post-crisis periods with respect to both CS and DI; and (ii) the pay-off components of the strategy trading on skew risk premia mimic the behavior of currency carry trades. We further reveal and rationalize the differences in the performances of currency portfolios doubly sorted by CS and DI. We propose a novel trading strategy that makes a trade-off of the time-variation in risk premia between low and high volatility regimes and is thereby almost immunized from risk reversals. It generates a sizable average excess return (6.69% per annum, the highest among several studied currency trading strategies over the sample period) and its alpha that cannot be explained by canonical risk factors, including hedge fund risk factors suggested by Fung and Hsieh (2001). Unlike other currency trading strategies, its cumulative wealth is driven by both exchange rate and yield components. We also investigate the behavior of currency momentum that is shown subject to credit risk, similarly to its stock market version (Avramov, Chordia, Jostova, and Philipov, 2007): Winner currencies performance well when sovereign default probability is low and loser currencies provide the hedge against this type of risk when sovereign default probability hikes up. The changes in global sovereign CDS spreads contribute 59% of the variation to the factor that captures the common dynamics of the currency trading strategies. From asset allocation perspective, a crash-averse investor is better off by allocating about 40% of the wealth to currency-misalignment portfolio and about 35% to crash-sensitive portfolio in tranquil period while reallocating about 85% of portfolio holdings to downside-insurance-cost strategy during the financial turmoil.