Sources of Risk in Currency Returns

Mikhail Chernov, Jeremy Graveline and Irina Zviadadze

No 8745, CEPR Discussion Papers from C.E.P.R. Discussion Papers

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.

Keywords: Bayesian mcmc; Carry trades; Exchange rates; Implied volatility; Jumps (search for similar items in EconPapers)
JEL-codes: C58 F31 G12 (search for similar items in EconPapers)
Date: 2012-01
New Economics Papers: this item is included in nep-ifn and nep-mon
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (6)

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