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Pricing Risks Across Currency Denominations

Author

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  • Thomas A. Maurer

    (Faculty of Business and Economics, The University of Hong Kong, Hong Kong)

  • Thuy-Duong Tô

    (School of Banking and Finance, UNSW Business School, The University of New South Wales, Kensington, New South Wales 2052, Australia)

  • Ngoc-Khanh Tran

    (Olin Business School, Washington University in St. Louis, St. Louis, Missouri 63130)

Abstract

We use principal component analysis on 55 bilateral exchange rates of 11 developed currencies to identify two important global risk sources in foreign exchange (FX) markets. The risk sources are related to Carry and Dollar but are not spanned by these factors. We estimate the market prices associated with the two risk sources in the cross-section of FX market returns and construct FX market-implied country-specific stochastic discount factors (SDFs). The SDF volatilities are related to interest rates and expected carry trade returns in the cross-section. The SDFs price international stock returns and are related to important financial stress indicators and macroeconomic fundamentals. The first principal risk is associated with the Treasury-EuroDollar (TED) spread, quantities measuring volatility, tail and contagion risks, and future economic growth. It earns a relatively small implied Sharpe ratio. The second principal risk is associated with the default and term spreads and quantities capturing volatility and illiquidity risks. It further correlates with future changes in the long-term interest rate and earns a large implied Sharpe ratio.

Suggested Citation

  • Thomas A. Maurer & Thuy-Duong Tô & Ngoc-Khanh Tran, 2019. "Pricing Risks Across Currency Denominations," Management Science, INFORMS, vol. 65(11), pages 5308-5336, November.
  • Handle: RePEc:inm:ormnsc:v:65:y:2019:i:11:p:5308-5336
    DOI: 10.1287/mnsc.2018.3109
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    2. Bekaert, Geert & Panayotov, George, 2020. "Good Carry, Bad Carry," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 55(4), pages 1063-1094, June.
    3. Jun Wei, 2020. "Optimal Combination of Currency Assets and Algorithm Simulation under Exchange Rate Risk," Complexity, Hindawi, vol. 2020, pages 1-10, November.
    4. Zuzana Rowland & George Lazaroiu & Ivana Podhorská, 2020. "Use of Neural Networks to Accommodate Seasonal Fluctuations When Equalizing Time Series for the CZK/RMB Exchange Rate," Risks, MDPI, Open Access Journal, vol. 9(1), pages 1-21, December.

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