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US Equity Tail Risk and Currency Risk Premia

Author

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  • Zhenzhen Fan
  • Juan M. Londono
  • Xiao Xiao

Abstract

We find that a US equity tail risk factor constructed from out-of-the-money S&P 500 put option prices explains the cross-sectional variation of currency excess returns. Currencies highly exposed to this factor offer a low currency risk premium because they appreciate when US tail risk increases. In a reduced-form model, we show that country-specific tail risk factors are priced in the cross section of currency returns only if they contain a global risk component. Motivated by the intuition from the model and by our empirical results, we construct a novel proxy for a global tail risk factor by buying currencies with high US equity tail beta and shorting currencies with low US tail beta. This factor, along with the dollar risk factor, explains a large portion of the cross-sectional variation in the currency carry and momentum portfolios and outperforms other models widely used in the literature.

Suggested Citation

  • Zhenzhen Fan & Juan M. Londono & Xiao Xiao, 2019. "US Equity Tail Risk and Currency Risk Premia," International Finance Discussion Papers 1253, Board of Governors of the Federal Reserve System (U.S.).
  • Handle: RePEc:fip:fedgif:1253
    DOI: 10.17016/IFDP.2019.1253
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    File URL: https://www.federalreserve.gov/econres/ifdp/files/ifdp1253.pdf
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    References listed on IDEAS

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    More about this item

    Keywords

    Equity tail risk; Global tail risk; Currency returns; Carry trade; Currency momentum;

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • F31 - International Economics - - International Finance - - - Foreign Exchange

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