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Sources of 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 reported for the carry trade. 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) Gaussian 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 find that the probability of a jump depreciation (appreciation) in the exchange rate 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. Overall, jumps account for 25% of total currency risk over horizons of one to three months.

Suggested Citation

  • Chernov, Mikhail & Graveline, Jeremy & Zviadadze, Irina, 2012. "Sources of Risk in Currency Returns," CEPR Discussion Papers 8745, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:8745
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    1. repec:now:jnlcfr:104.00000051 is not listed on IDEAS
    2. Philippe Mueller & Andreas Stathopoulos & Andrea Vedolin, "undated". "International Correlation Risk," FMG Discussion Papers dp716, Financial Markets Group.
    3. Andreas Stathopoulos & Adrien Verdelhan & Hanno Lustig, 2017. "Nominal Exchange Rate Stationarity and Long-Term Bond Returns," 2017 Meeting Papers 1633, Society for Economic Dynamics.
    4. Hanno Lustig & Andreas Stathopoulos & Adrien Verdelhan, 2013. "The Term Structure of Currency Carry Trade Risk Premia," NBER Working Papers 19623, National Bureau of Economic Research, Inc.
    5. Daniel, Kent & Hodrick, Robert J. & Lu, Zhongjin, 2017. "The Carry Trade: Risks and Drawdowns," Critical Finance Review, now publishers, vol. 6(2), pages 211-262, September.
    6. Huang, Huichou & MacDonald, Ronald & Zhao, Yang, 2012. "Global Currency Misalignments, Crash Sensitivity, and Downside Insurance Costs," MPRA Paper 53745, University Library of Munich, Germany, revised 18 Nov 2013.
    7. Andreas Stathopoulos & Adrien Verdelhan & Hanno Lustig, 2014. "The Term Structure of Currency Carry Trade Risk Premia," 2014 Meeting Papers 837, Society for Economic Dynamics.

    More about this item

    Keywords

    Bayesian MCMC; carry trades; exchange rates; implied volatility; jumps;

    JEL classification:

    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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