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20
HabitBased Explanation of the Exchange Rate Risk Premium
, 2005
"... This paper presents a fully rational general equilibrium model that produces a timevarying exchange rate risk premium and solves the uncovered interest rate parity (U.I.P) puzzle. In this twocountry model, agents are characterized by slowmoving external habit preferences derived from Campbell & Co ..."
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Cited by 35 (5 self)
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This paper presents a fully rational general equilibrium model that produces a timevarying exchange rate risk premium and solves the uncovered interest rate parity (U.I.P) puzzle. In this twocountry model, agents are characterized by slowmoving external habit preferences derived from Campbell & Cochrane (1999). Endowment shocks are i.i.d and real riskfree rates are timevarying. Agents can trade across countries, but when a unit is shipped, only a fraction of the good arrives to the foreign shore. The model gives a rationale for the U.I.P puzzle: the domestic investor receives a positive exchange rate risk premium when she is more riskaverse than her foreign counterpart. Times of high riskaversion correspond to low interest rates. Thus, the domestic investor receives a positive risk premium when interest rates are lower at home than abroad. The model is both simulated and estimated. The simulation recovers the usual negative coefficient between exchange rate variations and interest rate differentials. When the iceberglike trade cost is taken into account, the exchange rate variance produced is in line with its empirical counterpart. A nonlinear estimation of the model using consumption data leads to reasonable parameters when pricing the foreign excess returns of an American investor.
Carry trades and currency crashes
 in D. Acemoglu, K. Rogoff & M. Woodford, eds, ‘NBER Macroeconomics Annual 2008
, 2008
"... This paper documents that carry traders are subject to crash risk: i.e. exchange rate movements between highinterestrate and lowinterestrate currencies are negatively skewed. We argue that this negative skewness is due to sudden unwinding of carry trades, which tend to occur in periods in which ..."
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Cited by 27 (6 self)
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This paper documents that carry traders are subject to crash risk: i.e. exchange rate movements between highinterestrate and lowinterestrate currencies are negatively skewed. We argue that this negative skewness is due to sudden unwinding of carry trades, which tend to occur in periods in which risk appetite and funding liquidity decrease. Funding liquidity measures predict exchange rate movements, and controlling for liquidity helps explain the uncovered interestrate puzzle. Carrytrade losses reduce future crash risk, but increase the price of crash risk. We also document excess comovement among currencies with similar interest rate. Our findings are consistent with a model in which carry traders are subject to funding liquidity constraints.
TimeVarying Risk, Interest Rates, and Exchange Rates in General Equilibrium
, 2005
"... Timevarying risk is the primary force driving nominal interest rate differentials on currencydenominated bonds. This finding is an immediate implication of the fact that exchange rates are roughly random walks. We show that a general equilibrium monetary model with an endogenous source of risk vari ..."
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Cited by 25 (4 self)
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Timevarying risk is the primary force driving nominal interest rate differentials on currencydenominated bonds. This finding is an immediate implication of the fact that exchange rates are roughly random walks. We show that a general equilibrium monetary model with an endogenous source of risk variation–a variable degree of asset market segmentation–can produce key features of actual interest rates and exchange rates. The endogenous segmentation arises from a fixed cost for agents to exchange money for assets. As inflation varies, the benefit ofassetmarketparticipation varies, and that changes the fraction of agents participating. These effects lead the risk premium to vary systematically with the level of inflation. Our model produces variation in the risk premium even though the fundamental shocks have constant conditional variances.
Rare Disasters and Exchange Rates
, 2008
"... We propose a new model of exchange rates, which yields a theory of the forward premium puzzle. Our explanation combines two ingredients: the possibility of rare economic disasters, and an asset view of the exchange rate. Our model is frictionless, has complete markets, and works for an arbitrary num ..."
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Cited by 7 (0 self)
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We propose a new model of exchange rates, which yields a theory of the forward premium puzzle. Our explanation combines two ingredients: the possibility of rare economic disasters, and an asset view of the exchange rate. Our model is frictionless, has complete markets, and works for an arbitrary number of countries. In the model, rare worldwide disasters can occur and affect each country’s productivity. Each country’s exposure to disaster risk varies over time according to a meanreverting process. Risky countries command high risk premia: they feature a depreciated exchange rate and a high interest rate. As their risk premium mean reverts, their exchange rate appreciates. Therefore, currencies of high interest rate countries appreciate on average. To make the notion of disaster risk more implementable, we show how options prices might in principle uncover latent disaster risk, and help forecast exchange rate movements. We then extend the framework to incorporate two factors: a disaster risk factor, and a business cycle factor. We calibrate the model and obtain quantitatively realistic values for the volatility of the exchange rate, the forward premium puzzle regression coefficients, and nearrandom walk exchange rate dynamics. Finally, we solve a model of stock markets across countries, which yields a series of predictions about the joint behavior of exchange rates, bonds, options and stocks across countries. The evidence from the options market appears to be supportive of the
Productionbased measures of risk for asset pricing
 Journal of Monetary Economics
, 2010
"... A stochastic discount factor for asset returns is recovered from equilibrium marginal rates of transformation of output across states of nature, inferred from the producers’ first order conditions. The marginal rate of transformation implies a novel macrofactor asset pricing model that does a reason ..."
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Cited by 7 (1 self)
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A stochastic discount factor for asset returns is recovered from equilibrium marginal rates of transformation of output across states of nature, inferred from the producers’ first order conditions. The marginal rate of transformation implies a novel macrofactor asset pricing model that does a reasonable job explaining the cross section of stock returns with plausible parameter values. Using a flexible representation of the firms ’ production technology, the producers ’ ability to transform output across states of nature is estimated to be high, in contrast with what is typically assumed in standard aggregate representations of the firms ’ production technology.
Common Risk Factors in Currency Markets
, 2008
"... Currency excess returns are highly predictable and strongly countercyclical. The average excess returns on low interest rate currencies are 4.8 percent per annum smaller than those on high interest rate currencies after accounting for transaction costs. A single returnbased factor, the return on t ..."
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Cited by 5 (0 self)
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Currency excess returns are highly predictable and strongly countercyclical. The average excess returns on low interest rate currencies are 4.8 percent per annum smaller than those on high interest rate currencies after accounting for transaction costs. A single returnbased factor, the return on the highest minus the return on the lowest interest rate currency portfolios, explains the crosssectional variation in average currency excess returns from low to high interest rate currencies. In a simple affine pricing model, we show that the highminuslow currency return measures that component of the stochastic discount factor innovations that is common across countries. To match the carry trade returns in the data, low interest rate currencies need to load more on this common innovation when the market price of global risk is high.
CrashNeutral Currency Carry Trades
, 2008
"... Currency carry trades exploiting violations of uncovered interest rate parity in G10 currencies have historically delivered significant excess returns with annualized Sharpe ratios nearly twice that of the U.S. equity market (19902008). Using data on foreign exchange options, this paper investigate ..."
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Cited by 5 (0 self)
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Currency carry trades exploiting violations of uncovered interest rate parity in G10 currencies have historically delivered significant excess returns with annualized Sharpe ratios nearly twice that of the U.S. equity market (19902008). Using data on foreign exchange options, this paper investigates whether these returns represent compensation for exposure to currency crashes. After eliminating net dollar exposure and hedging crash risk, excess returns to crashneutral currency carry trades are statistically indistinguishable from zero; returns to nondollarneutral portfolios remain positive, but are only weakly significant. The choice of option maturity has a significant impact on the realized excess returns, with quarterly hedging producing annualized returns that are 12 % higher than those obtained from monthly hedging.
Global Currency Hedging
, 2006
"... This paper considers the risk management problem of an investor who holds a diversified portfolio of global equities and chooses long or short positions in currencies to manage the risk of the equity portfolio. Over the period 19752005, we find that the Australian dollar, Canadian dollar, Japanese ..."
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Cited by 4 (0 self)
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This paper considers the risk management problem of an investor who holds a diversified portfolio of global equities and chooses long or short positions in currencies to manage the risk of the equity portfolio. Over the period 19752005, we find that the Australian dollar, Canadian dollar, Japanese yen, and British pound are positively correlated with their domestic stock markets and with the global equity market, but the euro, the Swiss franc, and especially the US dollar are negatively correlated with global equities. These correlations imply that riskminimizing global investors should short the Australian and Canadian dollars, yen, and pound but should hold long positions in the US dollar, the euro, and the Swiss franc. Accordingly, US investors should overhedge foreign equity positions except those in euro countries, which should only be partially hedged. These conclusions are robust to variations in the investment horizon. In the past 15 years the negative equity correlation of the dollar appears to have weakened slightly, while that of the euro has strengthened.
Investing in Foreign Currency is like Betting on your Intertemporal Marginal Rate of Substitution.
, 2005
"... Investors earn positive excess returns on high interest rate foreign discount bonds, because these currencies appreciate on average. Lustig and Verdelhan (2005) show that investing in high interest rate foreign discount bonds exposes them to more aggregate consumption risk, while low interest rate f ..."
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Cited by 1 (0 self)
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Investors earn positive excess returns on high interest rate foreign discount bonds, because these currencies appreciate on average. Lustig and Verdelhan (2005) show that investing in high interest rate foreign discount bonds exposes them to more aggregate consumption risk, while low interest rate foreign bonds provide a hedge. This paper provides a simple model that replicates these facts. Investing in foreign currency is like betting on the difference between your own intertemporal; marginal rate of substitution (IMRS) and your neighbor’s IMRS. These bets are very risky if your neighbor’s IMRS is not correlated with yours, but they provide a hedge when his IMRS is highly correlated and more volatile. If the foreign neighbors that face low interest rates also have more volatile and correlated IMRS, that accounts for the spread in excess returns in the data. Keywords: Exchange Rates, Currency Risk. 1