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Pricing Risks across Currency Denominations

Last Updated on 10 February, 2024 by Rejaul Karim

The research paper titled “Pricing Risks across Currency Denominations” authored by Thomas Andreas Maurer, Thuy Duong To, and Ngoc-Khanh Tran explores the crucial developments in FX markets.

Using principal component analysis, the paper identifies two key global risk sources in foreign exchange markets related to Carry and Dollar, which are not spanned by these factors.

By estimating the market prices associated with these risk sources in FX market returns, the authors have constructed FX market implied country-specific stochastic discount factors (SDFs).

Additionally, the SDF volatilities are related to interest rates and expected carry trade returns in the cross-section, contributing to the pricing and understanding of international stock returns.

Abstract Of Paper

We use principal component analysis on 55 bilateral exchange rates of 11 developed currencies to identify two important global risk sources in 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 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 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.

Original paper – Download PDF

Here you can download the PDF and original paper of Pricing Risks across Currency Denominations.

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Author

Thomas Andreas Maurer
The University of Hong Kong; Washington University in St. Louis – John M. Olin Business School; London School of Economics & Political Science (LSE)

Thuy Duong To
University of New South Wales, Sydney; Financial Research Network (FIRN)

Ngoc-Khanh Tran
Finance Dept., Pamplin College of Business, Virginia Tech; Olin Business School- Washington University in St. Louis

Conclusion

In conclusion, the research paper has significantly contributed to the understanding of currency risks and the implications for carry trades in the cross-section of FX market returns.

By identifying crucial global risk sources and estimating the market prices associated with these risks, the authors have provided valuable insights into the pricing of risks across different currency denominations.

Furthermore, the correlations between SDF volatilities, financial stress indicators, and macroeconomic fundamentals highlighted in the paper indicate the potential to better understand and predict international stock returns.

The findings established in this research carry immense significance for financial markets and global risk management strategies.

Related Reading:

Cross-Asset Return Predictability: Carry Trades, Stocks and Commodities

Off the Golden Fetters: Examining Interwar Carry Trade and Momentum

FAQ

Q1: What are the key findings of the research paper “Pricing Risks across Currency Denominations”?

A1: The paper identifies two important global risk sources in foreign exchange markets related to Carry and Dollar using principal component analysis. These risk sources are not spanned by these factors. The authors estimate the market prices associated with these 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. The SDFs also price international stock returns and are related to financial stress indicators and macroeconomic fundamentals.

Q2: How does the paper contribute to the understanding of currency risks and carry trades?

A2: The paper contributes by providing insights into the crucial global risk sources in FX markets and estimating market prices associated with these risks. The construction of FX market implied country-specific SDFs allows for a deeper understanding of the relationships between SDF volatilities, interest rates, carry trade returns, and international stock returns. The findings have implications for the pricing of risks across different currency denominations.

Q3: What are the implications of the research findings for financial markets and risk management strategies?

A3: The research findings have significant implications for financial markets as they contribute to understanding the dynamics of currency risks and their impact on international stock returns. The correlations between SDF volatilities, financial stress indicators, and macroeconomic fundamentals offer potential insights for predicting international stock returns. This information can be valuable for developing more informed risk management strategies in the context of currency markets.

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