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Equity Tail Risk and Currency Risk Premiums

Last Updated on 10 February, 2024 by Rejaul Karim

In the research paper “Equity Tail Risk and Currency Risk Premiums” by Zhenzhen Fan, Juan M. Londono, and Xiao Xiao, a profound association between option-based equity tail risk and the pricing of currency returns is established.

The study unveils that currencies exposed to an option-based equity tail risk factor tend to offer lower risk premiums as they serve as a hedge against equity tail risk. Notably, the research identifies a portfolio strategy that capitalizes on currencies with high equity tail beta while shorting those with low beta, effectively extracting the global component in the tail factor.

The estimated price of risk for this innovative global factor consistently exhibits a negative relationship with currency carry and momentum portfolios, as well as other asset class portfolios.

These findings suggest that the excess returns of these strategies may be attributed, in part, to compensations for global tail risk, offering invaluable insights into the intricate dynamics of currency risk premiums.

Abstract Of Paper

We find that an option-based equity tail risk factor is priced in the cross section of currency returns; more exposed currencies offer a low risk premium because they hedge against equity tail risk. A portfolio that buys currencies with high equity tail beta and shorts those with low beta extracts the global component in the tail factor. The estimated price of risk of this novel global factor is consistently negative in currency carry and momentum portfolios, and in portfolios of other asset classes, suggesting that excess returns of these strategies can be partially understood as compensations for global tail risk.

Original paper – Download PDF

Here you can download the PDF and original paper of Equity Tail Risk and Currency Risk Premiums.

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Author

Zhenzhen Fan
Gordon S Lang School of Business and Economics, University of Guelph, Guelph, Canada – Department of Economics and Finance

Juan M. Londono
Board of Governors of the Federal Reserve System

Xiao Xiao
City University London – Bayes Business School

Conclusion

The research presented in “Equity Tail Risk and Currency Risk Premiums” by Zhenzhen Fan, Juan M. Londono, and Xiao Xiao marks a significant shift in perspective on the relationship between option-implied equity tail risk and currency returns.

The study’s examination of a portfolio strategy that leverages currencies with high equity tail beta while shorting those with low beta yields a compelling insight into extracting the global component in the tail factor.

Furthermore, the consistently negative estimated price of risk for this novel global factor across currency carry, momentum portfolios, and other asset classes emphasizes the role of compensations for global tail risk in influencing the excess returns of these strategies.

This research not only advances our comprehension of currency risk premiums but also provides a nuanced perspective on understanding the underlying mechanisms behind the dynamics of equity tail risk. It stands as a profound and innovative contribution to the field of financial economics.

Related Reading:

Corruption, Carry Trades, and the Cross Section of Currency Returns

Countercyclical Currency Risk Premia

FAQ

Q1: What is the main finding of the research paper “Equity Tail Risk and Currency Risk Premiums” by Zhenzhen Fan, Juan M. Londono, and Xiao Xiao?

A1: The main finding of the research paper is the establishment of a profound association between option-based equity tail risk and the pricing of currency returns. Currencies exposed to an option-based equity tail risk factor tend to offer lower risk premiums, serving as a hedge against equity tail risk. The study introduces a portfolio strategy that buys currencies with high equity tail beta and shorts those with low beta, effectively extracting the global component in the tail factor.

Q2: How does the research paper link option-based equity tail risk to currency returns, and what role do currencies play in hedging equity tail risk?

A2: The research paper links option-based equity tail risk to currency returns by demonstrating that currencies exposed to this risk factor provide lower risk premiums. Currencies, in this context, play a role as a hedge against equity tail risk. The study finds that more exposed currencies offer a low risk premium, suggesting that investors are willing to accept lower returns on these currencies as they serve as a hedge in the presence of equity tail risk.

Q3: What is the portfolio strategy introduced in the paper, and how does it contribute to understanding the global component in the tail factor?

A3: The paper introduces a portfolio strategy that involves buying currencies with high equity tail beta and shorting those with low beta. This strategy is designed to extract the global component in the tail factor. By implementing this portfolio strategy, the study provides insights into how currencies with different exposures to equity tail risk can be combined to capture the global element of the tail factor.

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