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Option-Implied Currency Risk Premia

Last Updated on 10 February, 2024 by Rejaul Karim

In the research paper “Option-Implied Currency Risk Premia” by Jakub W. Jurek and Zhikai Xu, the focus is on obtaining ex-ante estimates of risk premia for G10 currency pairs using cross-sectional data on exchange rate options. The authors explore the use of a non-Gaussian, two-factor model that aligns with evidence from realized currency returns.

The findings reveal that option-implied currency risk premia serve as an unbiased forecast of monthly currency excess returns, showcasing impressive cross-sectional forecasting R^2s of up to 44%.

Despite the presence of non-normalities in option data, the authors establish that a minimal proportion of the model HML-FX risk premium accounts for the asymmetries and higher-moments of global risks, which equates to approximately 70bps per annum.

Abstract Of Paper

We obtain ex ante estimates of risk premia for G10 currency pairs using cross-sectional data on exchange rate options. Option prices are well-matched by a non-Gaussian, two-factor model, consistent with evidence from realized currency returns. We find that option-implied currency risk premia provide an unbiased forecast of monthly currency excess returns, and achieve cross-sectional forecasting R^2s of up to 44%. Despite prominent non-normalities in option data, less than 20% of the model HML-FX risk premium, or roughly 70bps per annum, is due to the asymmetries and higher-moments of global risks.

Original paper – Download PDF

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Author

Jakub W. Jurek
University of Pennsylvania – Finance Department; National Bureau of Economic Research (NBER)

Zhikai Xu
AQR Capital Management, LLC

Conclusion

In conclusion, the research paper “Option-Implied Currency Risk Premia” sheds light on the significance of option-implied currency risk premia as a reliable predictor of monthly currency excess returns.

The authors’ use of a non-Gaussian, two-factor model aligns with empirical evidence from realized currency returns, reinforcing the validity of their findings. The revelation that less than 20% of the model HML-FX risk premium is attributable to asymmetries and higher-moments of global risks is a thought-provoking takeaway, implying the robustness of option-implied currency risk premia in forecasting currency fluctuations.

This research paves the way for further exploration into the utilization of option-implied risk premia in currency markets, offering valuable insights for investors and policymakers.

Related Reading:

Is Currency Momentum a Hedge for Global Economic Risk?

Systematic Intervention and Currency Risk Premia

FAQ

Q1: What is the main focus of the research paper “Option-Implied Currency Risk Premia” by Jakub W. Jurek and Zhikai Xu?

A1: The main focus of the research paper is to obtain ex-ante estimates of risk premia for G10 currency pairs using cross-sectional data on exchange rate options. The authors explore the use of a non-Gaussian, two-factor model that is consistent with evidence from realized currency returns.

Q2: What are the key findings regarding option-implied currency risk premia in the study?

A2: The study finds that option-implied currency risk premia serve as an unbiased forecast of monthly currency excess returns. The authors report impressive cross-sectional forecasting R^2s of up to 44%. Despite the presence of non-normalities in option data, less than 20% of the model HML-FX risk premium is attributed to asymmetries and higher-moments of global risks, which equates to approximately 70 basis points per annum.

Q3: How well does the non-Gaussian, two-factor model used in the study align with empirical evidence from realized currency returns?

A3: The non-Gaussian, two-factor model used in the study aligns well with empirical evidence from realized currency returns. This alignment adds credibility to the model’s effectiveness in capturing the dynamics of currency risk premia.

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