Currency returns and downside risk: Debt, volatility, and the gap from benchmark values

Nevin Cavusoglu, Michael D. Goldberg and Josh Stillwagon ()

Journal of Macroeconomics, 2021, vol. 68, issue C

Abstract: The paper considers competing portfolio-balance specifications of currency returns, including one based on expected utility theory and another on prospect theory. The prospect theory specification relates downside risk to the gap between the exchange rate and its benchmark value. The empirical analysis uses survey data on exchange rate expectations to test directly the models’ predictions concerning ex ante excess returns. It also relies on the cointegrated VAR framework, which is well suited for testing competing models and dealing with unit roots. Like earlier studies, we find little support for the expected utility theory model in three major currency markets. By contrast, the prospect theory model’s predictions are largely borne out in the data, including those about sign reversals. We find the strongest support for a hybrid model that incorporates the risk factors of both models.

Keywords: International CAPM; Prospect theory; Risk premium; Cointegrated VAR; Survey expectations; Downside risk (search for similar items in EconPapers)
JEL-codes: D81 D84 F31 G02 (search for similar items in EconPapers)
Date: 2021
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:jmacro:v:68:y:2021:i:c:s0164070421000161

DOI: 10.1016/j.jmacro.2021.103304

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