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Currency Network Risk

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  • Mykola Babiak
  • Jozef Barunik

Abstract

This paper identifies new currency risk stemming from a network of idiosyncratic option-based currency volatilities and shows how such network risk is priced in the cross-section of currency returns. A portfolio that buys net-receivers and sells net-transmitters of short-term linkages between currency volatilities generates a significant Sharpe ratio. The network strategy formed on causal connections is uncorrelated with popular benchmarks and generates a significant alpha, while network returns formed on aggregate connections, which are driven by a strong correlation component, are partially subsumed by standard factors. Long-term linkages are priced less, indicating a downward-sloping term structure of network risk.

Suggested Citation

  • Mykola Babiak & Jozef Barunik, 2021. "Currency Network Risk," Papers 2101.09738, arXiv.org, revised Jul 2021.
  • Handle: RePEc:arx:papers:2101.09738
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    References listed on IDEAS

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