Sources of risk in the foreign exchange market [electronic resource]

Zviadadze, Irina (2013) Sources of risk in the foreign exchange market [electronic resource]. Doctoral thesis, University of London: London Business School.

Abstract

I quantify alternative sources of risk in currency returns. Firstly, in a joint work with Mikhail Chernov and Jeremy Graveline, we focus on crash risk. We develop and estimate an empirical model of currency returns that includes normal shocks with stochastic variance, jumps up and down in the exchange rate, and jumps in the variance. We identify these components using daily data on exchange rates and at-the-money implied variances. We find that crash risk is time-varying. The probability of a jump in the exchange rate, associated with depreciation (appreciation) of the US dollar, is increasing in the domestic (foreign) interest rate. The probability of a jump in variance is increasing in the variance. Many of the jumps in exchange rates are associated with macroeconomic and political news, but jumps in variance are not. On average, jumps account for 25% of total currency risk, as measured by the entropy of exchange rate changes, over horizons of one to three months. Preliminary analysis suggests that jump risk is priced. Secondly, I quantify the risk-return relationship in the foreign exchange market in crosssection and across investment horizons by focusing on the role of multiple sources of consumption risk. I estimate a flexible structural model of the joint dynamics of aggregate consumption, inflation, nominal interest rate, and stochastic variance with cross-equation restrictions implied by recursive preferences. I identify short-run, long-run, variance consumption risks and inflation risk. I find that the long-run consumption risk plays a prominent role: it carries a Sharpe ratio of 0.66 and contributes the most to the level and spread of excess returns between high and low interest rate currencies at alternative investment horizons. The short-run consumption risk has an effect at the horizon of one quarter only, where it explains at least 26% of the corresponding spread in excess returns.