IDEAS home Printed from https://ideas.repec.org/p/ecl/ohidic/2012-24.html
   My bibliography  Save this paper

Probability Weighting of Rare Events and Currency Returns

Author

Listed:
  • Chabi-Yo, Fousseni

    (OH State University)

  • Song, Zhaogang

    (Federal Reserve Board)

Abstract

We show that the probability weighting of rare events, accounting for investors' attitudes toward extreme downside losses versus upside gains in non-expected utility models, provides a unified explanation for both time-series and cross-sectional variations of currency portfolio returns. We use a simple structural model to show the link between the probability weighting function and pricing kernel, and then estimate them by non-parametric methods using currency options data from 1996 to 2012. The estimates show that a domestic investor over-weights the likelihood of a substantial depreciation or appreciation of foreign currencies, consistent with experimental studies. A global probability weighting measure of left (right) tail events is highly significant in positively (negatively) predicting future currency returns over time series at both individual and portfolios levels. Furthermore, asset pricing tests show that differences in exposure to our global tail weighting measures, of high versus low interest rate currencies and of high versus low past return currencies, can explain the cross-sectional variation in average excess returns across both carry and momentum portfolios. Moreover, our global tail weighting measures remain significant after controlling for existing currency risk factors in the literature, and frequently drive their significance out, in both time-series and cross-sectional return predictability regressions.

Suggested Citation

  • Chabi-Yo, Fousseni & Song, Zhaogang, 2012. "Probability Weighting of Rare Events and Currency Returns," Working Paper Series 2012-24, Ohio State University, Charles A. Dice Center for Research in Financial Economics.
  • Handle: RePEc:ecl:ohidic:2012-24
    as

    Download full text from publisher

    File URL: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2176788
    Download Restriction: no

    References listed on IDEAS

    as
    1. Joao Gomes & Leonid Kogan & Lu Zhang, 2003. "Equilibrium Cross Section of Returns," Journal of Political Economy, University of Chicago Press, vol. 111(4), pages 693-732, August.
    2. Fama, Eugene F & French, Kenneth R, 1992. " The Cross-Section of Expected Stock Returns," Journal of Finance, American Finance Association, vol. 47(2), pages 427-465, June.
    3. Greg Huffman, 2007. "Endogenous Growth Through Investment-Specific Technological Change," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 10(4), pages 615-645, October.
    4. Greenwood, Jeremy & Hercowitz, Zvi & Krusell, Per, 2000. "The role of investment-specific technological change in the business cycle," European Economic Review, Elsevier, vol. 44(1), pages 91-115, January.
    5. John H. Cochrane, 1997. "Where is the market going? Uncertain facts and novel theories," Economic Perspectives, Federal Reserve Bank of Chicago, issue Nov, pages 3-37.
    6. Rui Albuquerue & Neng Wang, 2008. "Agency Conflicts, Investment, and Asset Pricing," Journal of Finance, American Finance Association, vol. 63(1), pages 1-40, February.
    7. John Y. Campbell, 2001. "Have Individual Stocks Become More Volatile? An Empirical Exploration of Idiosyncratic Risk," Journal of Finance, American Finance Association, vol. 56(1), pages 1-43, February.
    8. Frederico Belo & Xiaoji Lin & Santiago Bazdresch, 2014. "Labor Hiring, Investment, and Stock Return Predictability in the Cross Section," Journal of Political Economy, University of Chicago Press, vol. 122(1), pages 129-177.
    9. Tuomo Vuolteenaho, 2001. "What Drives Firm-Level Stock Returns?," NBER Working Papers 8240, National Bureau of Economic Research, Inc.
    10. Monika Merz & Eran Yashiv, 2007. "Labor and the Market Value of the Firm," American Economic Review, American Economic Association, vol. 97(4), pages 1419-1431, September.
    11. Saul Lach & Rafael Rob, 1996. "R&D, Investment, and Industry Dynamics," Journal of Economics & Management Strategy, Wiley Blackwell, vol. 5(2), pages 217-249, June.
    12. Aghion, Philippe & Howitt, Peter, 1992. "A Model of Growth through Creative Destruction," Econometrica, Econometric Society, pages 323-351.
    13. Lu Zhang, 2005. "The Value Premium," Journal of Finance, American Finance Association, vol. 60(1), pages 67-103, February.
    14. Christopher A. Hennessy & Toni M. Whited, 2007. "How Costly Is External Financing? Evidence from a Structural Estimation," Journal of Finance, American Finance Association, vol. 62(4), pages 1705-1745, August.
    15. Patrick Bolton & Hui Chen & Neng Wang, 2011. "A Unified Theory of Tobin's q, Corporate Investment, Financing, and Risk Management," Journal of Finance, American Finance Association, vol. 66(5), pages 1545-1578, October.
    16. Laura X. L. Liu & Toni Whited & Lu Zhang, 2007. "Regularities," NBER Working Papers 13024, National Bureau of Economic Research, Inc.
    17. Romer, Paul M, 1990. "Endogenous Technological Change," Journal of Political Economy, University of Chicago Press, vol. 98(5), pages 71-102, October.
    18. Greenwood, Jeremy & Hercowitz, Zvi & Krusell, Per, 1997. "Long-Run Implications of Investment-Specific Technological Change," American Economic Review, American Economic Association, pages 342-362.
    19. John Y. Campbell & John H. Cochrane, 1994. "By force of habit: a consumption-based explanation of aggregate stock market behavior," Working Papers 94-17, Federal Reserve Bank of Philadelphia.
    20. Jonas D. M. Fisher, 2006. "The Dynamic Effects of Neutral and Investment-Specific Technology Shocks," Journal of Political Economy, University of Chicago Press, vol. 114(3), pages 413-451, June.
    21. Fama, Eugene F. & French, Kenneth R., 1993. "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 33(1), pages 3-56, February.
    22. Louis K. C. Chan, 2001. "The Stock Market Valuation of Research and Development Expenditures," Journal of Finance, American Finance Association, vol. 56(6), pages 2431-2456, December.
    23. King, Robert G. & Rebelo, Sergio T., 1999. "Resuscitating real business cycles," Handbook of Macroeconomics,in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 14, pages 927-1007 Elsevier.
    24. Laura Xiaolei Liu & Toni M. Whited & Lu Zhang, 2009. "Investment-Based Expected Stock Returns," Journal of Political Economy, University of Chicago Press, vol. 117(6), pages 1105-1139, December.
    25. Titman, Sheridan & Wei, K. C. John & Xie, Feixue, 2004. "Capital Investments and Stock Returns," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 39(04), pages 677-700, December.
    26. Galeotti, Marzio & Schiantarelli, Fabio, 1991. "Generalized Q Models for Investment," The Review of Economics and Statistics, MIT Press, vol. 73(3), pages 383-392, August.
    27. Owen A. Lamont, 2000. "Investment Plans and Stock Returns," Journal of Finance, American Finance Association, vol. 55(6), pages 2719-2745, December.
    28. Greenwood, J. & Jovanovic, B., 1999. "The IT Revolution and the Stock Market," Working Papers 99-02, C.V. Starr Center for Applied Economics, New York University.
    29. Cochrane, John H, 1996. "A Cross-Sectional Test of an Investment-Based Asset Pricing Model," Journal of Political Economy, University of Chicago Press, vol. 104(3), pages 572-621, June.
    30. Mas-Colell, Andreu & Whinston, Michael D. & Green, Jerry R., 1995. "Microeconomic Theory," OUP Catalogue, Oxford University Press, number 9780195102680.
    31. Lawrence J. Christiano & Michele Boldrin & Jonas D. M. Fisher, 2001. "Habit Persistence, Asset Returns, and the Business Cycle," American Economic Review, American Economic Association, vol. 91(1), pages 149-166, March.
    32. Ellen R. McGrattan & Edward C. Prescott, 2005. "Taxes, Regulations, and the Value of U.S. and U.K. Corporations," Review of Economic Studies, Oxford University Press, vol. 72(3), pages 767-796.
    33. Cochrane, John H, 1991. " Production-Based Asset Pricing and the Link between Stock Returns and Economic Fluctuations," Journal of Finance, American Finance Association, vol. 46(1), pages 209-237, March.
    34. Lin, Ping & Saggi, Kamal, 2002. "Product differentiation, process R&D, and the nature of market competition," European Economic Review, Elsevier, vol. 46(1), pages 201-211, January.
    35. Christopher A. Hennessy & Toni M. Whited, 2005. "Debt Dynamics," Journal of Finance, American Finance Association, vol. 60(3), pages 1129-1165, June.
    36. Hsu, Po-Hsuan, 2009. "Technological innovations and aggregate risk premiums," Journal of Financial Economics, Elsevier, vol. 94(2), pages 264-279, November.
    37. Dmitry Livdan & Horacio Sapriza & Lu Zhang, 2009. "Financially Constrained Stock Returns," Journal of Finance, American Finance Association, vol. 64(4), pages 1827-1862, August.
    38. Yuhang Xing, 2008. "Interpreting the Value Effect Through the Q-Theory: An Empirical Investigation," Review of Financial Studies, Society for Financial Studies, vol. 21(4), pages 1767-1795, July.
    39. Murray Carlson & Adlai Fisher & Ron Giammarino, 2004. "Corporate Investment and Asset Price Dynamics: Implications for the Cross-section of Returns," Journal of Finance, American Finance Association, vol. 59(6), pages 2577-2603, December.
    40. Cohen, Wesley M & Klepper, Steven, 1996. "Firm Size and the Nature of Innovation within Industries: The Case of Process and Product R&D," The Review of Economics and Statistics, MIT Press, vol. 78(2), pages 232-243, May.
    41. Jermann, Urban J., 1998. "Asset pricing in production economies," Journal of Monetary Economics, Elsevier, vol. 41(2), pages 257-275, April.
    42. Hayashi, Fumio, 1982. "Tobin's Marginal q and Average q: A Neoclassical Interpretation," Econometrica, Econometric Society, vol. 50(1), pages 213-224, January.
    43. Belo, Frederico, 2010. "Production-based measures of risk for asset pricing," Journal of Monetary Economics, Elsevier, vol. 57(2), pages 146-163, March.
    44. Ilan Cooper, 2006. "Asset Pricing Implications of Nonconvex Adjustment Costs and Irreversibility of Investment," Journal of Finance, American Finance Association, vol. 61(1), pages 139-170, February.
    45. Richard C. Levin & Peter C. Reiss, 1988. "Cost-Reducing and Demand-Creating R&D with Spillovers," RAND Journal of Economics, The RAND Corporation, vol. 19(4), pages 538-556, Winter.
    Full references (including those not matched with items on IDEAS)

    More about this item

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:ecl:ohidic:2012-24. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (). General contact details of provider: http://edirc.repec.org/data/cdohsus.html .

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    We have no references for this item. You can help adding them by using this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service hosted by the Research Division of the Federal Reserve Bank of St. Louis . RePEc uses bibliographic data supplied by the respective publishers.