Uncertainty Network Risk and Currency Returns

Mykola Babiak and Jozef Baruník

CERGE-EI Working Papers from The Center for Economic Research and Graduate Education - Economics Institute, Prague

Abstract: We examine the pricing of a horizon specific uncertainty network risk, extracted from option implied variances on exchange rates, in the cross-section of currency returns. Buying currencies that are receivers and selling currencies that are transmitters of short-term shocks exhibits a high Sharpe ratio and yields a significant alpha when controlling for standard dollar, carry trade, volatility, variance risk premium and momentum strategies. This profitability stems primarily from the causal nature of shock propagation and not from contemporaneous dynamics. Shock propagation at longer horizons is priced less, indicating a downward-sloping term structure of uncertainty network risk in currency markets.

Keywords: foreign exchange rates; network risk; currency variance; predictability; term structure (search for similar items in EconPapers)
JEL-codes: F31 G12 G15 (search for similar items in EconPapers)
Date: 2021-02
New Economics Papers: this item is included in nep-cwa, nep-mon and nep-rmg
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