Currency Network Risk

Mykola Babiak and Jozef Baruník

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Abstract: This paper identifies new currency risk stemming from a network of idiosyncratic option-based currency volatilities and shows how such network risk is priced in the cross-section of currency returns. A portfolio that buys net-receivers and sells net-transmitters of short-term linkages between currency volatilities generates a significant Sharpe ratio. The network strategy formed on causal connections is uncorrelated with popular benchmarks and generates a significant alpha, while network returns formed on aggregate connections, which are driven by a strong correlation component, are partially subsumed by standard factors. Long-term linkages are priced less, indicating a downward-sloping term structure of network risk.

Date: 2021-01, Revised 2021-07
New Economics Papers: this item is included in nep-fmk and nep-net
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Persistent link: https://EconPapers.repec.org/RePEc:arx:papers:2101.09738

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