Pricing Risks Across Currency Denominations

Thomas Maurer, Thuy-Duong Tô () and Ngoc-Khanh Tran ()
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Thuy-Duong Tô: School of Banking and Finance, UNSW Business School, The University of New South Wales, Kensington, New South Wales 2052, Australia
Ngoc-Khanh Tran: Olin Business School, Washington University in St. Louis, St. Louis, Missouri 63130

Management Science, 2019, vol. 65, issue 11, 5308-5336

Abstract: We use principal component analysis on 55 bilateral exchange rates of 11 developed currencies to identify two important global risk sources in foreign exchange (FX) markets. The risk sources are related to Carry and Dollar but are not spanned by these factors. We estimate the market prices associated with the two risk sources in the cross-section of FX market returns and construct FX market-implied country-specific stochastic discount factors (SDFs). The SDF volatilities are related to interest rates and expected carry trade returns in the cross-section. The SDFs price international stock returns and are related to important financial stress indicators and macroeconomic fundamentals. The first principal risk is associated with the Treasury-EuroDollar (TED) spread, quantities measuring volatility, tail and contagion risks, and future economic growth. It earns a relatively small implied Sharpe ratio. The second principal risk is associated with the default and term spreads and quantities capturing volatility and illiquidity risks. It further correlates with future changes in the long-term interest rate and earns a large implied Sharpe ratio.

Keywords: international finance; FX; currency risk; carry trade; stochastic discount factor (SDF); permanent; transitory; principal component; international stock markets; macroeconomic fundamental; financial stress indicator (search for similar items in EconPapers)
Date: 2019
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Citations: View citations in EconPapers (13)

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