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Currency returns and downside risk: Debt, volatility, and the gap from benchmark values

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  • Cavusoglu, Nevin
  • Goldberg, Michael D.
  • Stillwagon, Josh

Abstract

The paper considers competing portfolio-balance specifications of currency returns, including one based on expected utility theory and another on prospect theory. The prospect theory specification relates downside risk to the gap between the exchange rate and its benchmark value. The empirical analysis uses survey data on exchange rate expectations to test directly the models’ predictions concerning ex ante excess returns. It also relies on the cointegrated VAR framework, which is well suited for testing competing models and dealing with unit roots. Like earlier studies, we find little support for the expected utility theory model in three major currency markets. By contrast, the prospect theory model’s predictions are largely borne out in the data, including those about sign reversals. We find the strongest support for a hybrid model that incorporates the risk factors of both models.

Suggested Citation

  • Cavusoglu, Nevin & Goldberg, Michael D. & Stillwagon, Josh, 2021. "Currency returns and downside risk: Debt, volatility, and the gap from benchmark values," Journal of Macroeconomics, Elsevier, vol. 68(C).
  • Handle: RePEc:eee:jmacro:v:68:y:2021:i:c:s0164070421000161
    DOI: 10.1016/j.jmacro.2021.103304
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    More about this item

    Keywords

    International CAPM; Prospect theory; Risk premium; Cointegrated VAR; Survey expectations; Downside risk;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • G02 - Financial Economics - - General - - - Behavioral Finance: Underlying Principles

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