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Crash 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 to currency speculation. 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) normal 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 nd that the probability of an upward (downward) jump in the exchange rate, associated with depreciation (appreciation) of the US dollar, 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. On average, jumps account for 25% (and can be as high as 40%) of total currency risk over horizons of one to three months. Preliminary analysis suggests that properties of currency returns correspond to observed option smiles and that jump risk is priced.
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  • Chernov, Mikhail & Graveline, Jeremy & Zviadadze, Irina, 2018. "Crash Risk in Currency Returns," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 53(01), pages 137-170, February.
  • Handle: RePEc:cup:jfinqa:v:53:y:2018:i:01:p:137-170_00
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    Cited by:

    1. Ready, Robert & Roussanov, Nikolai & Ward, Colin, 2017. "After the tide: Commodity currencies and global trade," Journal of Monetary Economics, Elsevier, vol. 85(C), pages 69-86.
    2. Juan M. Londono & Hao Zhou, 2012. "Variance risk premiums and the forward premium puzzle," International Finance Discussion Papers 1068, Board of Governors of the Federal Reserve System (U.S.).
    3. Louis Raffestin, 2016. "Foreign exchange investment rules and endogenous currency crashes," Working Papers hal-01277113, HAL.
    4. Kremens, Lukas & Martin, Ian, 2017. "The Quanto Theory of Exchange Rates," CEPR Discussion Papers 11970, C.E.P.R. Discussion Papers.
    5. Yang Liu & Mariano Croce & Ivan Shaliastovich & Ric Colacito, 2016. "Volatility Risk Pass-Through," 2016 Meeting Papers 135, Society for Economic Dynamics.

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