Currency carry trade regimes: Beyond the Fama regression

We show that carry trade strategies resemble FX option strategies that sell out of the money puts on high interest rate currencies. Both strategies collect premiums to generate persistent excess returns that unwind sharply when volatility increases. We also show that the widely documented negative slope coefficient in regressions of exchange rate depreciation on forward currency premiums is an artifact of the volatility regime. In high volatility regimes, the so-called Fama regression produces a positive coefficient greater than unity. We finally document the existence of an intuitive co-movement between currency risk premiums and yield curve risk factors.     

Local risk factors in emerging markets: Are they separately priced?

We provide new evidence on the pricing of local risk factors in emerging stock markets. We investigate whether there is a significant local currency premium together with a domestic market risk premium in equity returns within a partial integration asset pricing model. Given previous evidence on currency risk, we conduct empirical tests in a conditional setting with time-varying prices of risk. Our main results support the hypothesis of a significant exchange risk premium related to the local currency risk. Exchange rate and domestic market risks are priced separately for our sample of seven emerging markets. The empirical evidence also suggests that although statistically significant, local currency risk is on average smaller than domestic market risk but it increases substantially during crises periods, when it can be almost as large as market risk. Disentangling these two factors is thus important in tests of international asset pricing for emerging markets.     

Crash-neutral currency carry trades

Currency carry trades exploiting violations of uncovered interest rate parity in G10 currencies deliver significant excess returns with annualized Sharpe ratios equal to or greater than those of equity market factors (1990–2012). Using data on out-of-the-money foreign exchange options, I compute returns to crash-hedged portfolios and demonstrate that the high returns to carry trades are not due to peso problems. A comparison of the returns to hedged and unhedged trades indicates crash risk premia account for at most one-third of the excess return to currency carry trades.     

Stochastic risk premiums,stochastic skewness in currency options,and stochastic discount factors in international economies

We develop models of stochastic discount factors in international economies that produce stochastic risk premiums and stochastic skewness in currency options. We estimate the models using time-series returns and option prices on three currency pairs that form a triangular relation. Estimation shows that the average risk premium in Japan is larger than that in the US or the UK, the global risk premium is more persistent and volatile than the country-specific risk premiums, and investors respond differently to different shocks. We also identify high-frequency jumps in each economy but find that only downside jumps are priced. Finally, our analysis shows that the risk premiums are economically compatible with movements in stock and bond market fundamentals.     

Currency futures-spot basis and risk premium

This paper explores the usefulness of currency futures-spot basis in predicting spot rate changes and currency futures returns. We conjecture that the currency risk premium may be an important component of the basis for long-maturity futures contracts, but may not be so for short-maturities. Thus, the basis of long-maturity contracts cannot predict the spot rate changes between now and maturity, rejecting uncovered interest rate parity (UIP), but can predict currency futures returns, which are solely determined by the risk premium. Conversely, the basis of the short-maturity contracts can predict the spot rate changes between now and maturity, validating the UIP, but cannot predict currency futures returns. Empirical tests support these conjectures for the Japanese, British, Swiss, and German currencies over the last two decades. The results are also consistent with Longstaff [Longstaff, F., 2000. The term structure of very short-term rates: new evidence for the Expectation Hypothesis. Journal of Financial Economics 58, 397–415], who shows that the Expectations Hypothesis holds at the very short end of the term structure of interest rates.     

The Variation of Economic Risk Premiums in Real Estate Returns

We examine the predictable components of returns on stocks, bonds, and real estate investment trusts (REITs). We employ a multiple-beta asset pricing model and find that there are varying degrees of predictability among stocks, bonds, and REITs. Furthermore, we find that most of the predictability of returns is associated with the economic variables employed in the asset pricing model. The stock market risk premium is highly important in capturing the predictable variation in stock portfolios, and the bond market risk premiums (term and risk structure of interest rates) are important in capturing the predictable variation in bond portfolios. For REITs, however, both the stock and bond market risk premiums capture the predictable variation in returns. REITs have comparable return predictability to stock portfolios. We conclude that there is an important economic risk premium for REITs that are not captured by traditional multiple-beta asset pricing models.     

Idiosyncratic consumption risk and predictability of the carry trade premium: Euro-Area evidence

The failure to empirically prove uncovered interest rate parity conditions seems to be related to the presence of risk premia on foreign currencies. Recent studies suggest that either consumption- or currency-return-based pricing factors explain the cross section of foreign currency portfolio returns. The contribution of this paper is twofold. It first shows that the return-based explanation applies to foreign currency portfolios built from the perspective of a Euro-Area investor. Second, the main results of this paper suggest that the decisive pricing factor, the so-called carry trade premium, mirrors business-cycle-related risks. Times of relatively large uninsured Euro-Area consumption growth risk are associated with an expected increase of the carry trade premium.     

The world ex ante risk premium: an empirical investigation

A number of recent papers have focused on testing the linearity restrictions implied by international asset pricing models. The tests, however, have not addressed an additional restriction implied by the models; namely, that the risk premium on the world portfolio is positive. This study provides a direct assessment of this restriction. The evidence indicates that the ex ante world market risk premium can be negative. The results are robust to market proxies that are hedged and unhedged with respect to currency risk. Subperiod analysis indicates that the rejection of the positive risk premium restriction is driven by the first half of the sample period.     

Expected stock returns and volatility

This paper examines the relation between stock returns and stock market volatility. We find evidence that the expected market risk premium (the expected return on a stock portfolio minus the Treasury bill yield) is positively related to the predictable volatility of stock returns. There is also evidence that unexpected stock market returns are negatively related to the unexpected change in the volatility of stock returns. This negative relation provides indirect evidence of a positive relation between expected risk premiums and volatility.     

Exchange Rate Exposure at the Firm and Industry Level

Previous work on the exposure of firms to exchange rate risk has primarily focused on U.S. firms and, surprisingly, found stock returns were not significantly affected by exchange‐rate fluctuations. The equity market premium for exposure to currency risk was also found to be insignificant. In this paper we examine the relation between Japanese stock returns and unanticipated exchange‐rate changes for 1,079 firms traded on the Tokyo stock exchange over the 1975–1995 period. Second, we investigate whether exchange‐rate risk is priced in the Japanese equity market using both unconditional and conditional multifactor asset pricing testing procedures. We find a significant relation between contemporaneous stock returns and unanticipated yen fluctuations. The exposure effect on multinationals and high‐exporting firms, however, is found to be greater in comparison to low‐exporting and domestic firms. Lagged‐exchange rate changes on firm value are found to be statistically insignificant implying that investors are able to assess the impact of exchange‐rate changes on firm value with no significant delay. The industry level analysis corroborates the cross‐sectional findings for Japanese firms in that they are sensitive to contemporaneous unexpected exchange‐rate fluctuations. The co‐movement between stock returns and changes in the foreign value of the yen is found to be positively associated with the degree of the firm's foreign economic involvement and inversely related to its size and debt to asset ratio. Asset pricing tests show that currency risk is priced. We find corroborating evidence in support of the view that currency exposure is time varying. Our results indicate that the foreign exchange‐rate risk premium is a significant component of Japanese stock returns. The combined evidence from the currency exposure and asset pricing analyses, suggests that currency risk is priced and, therefoe, has implications for corporate and portfolio managers.     

Pricing mortgage insurance contracts under housing price cycles with jump risk: evidence from the U.K. housing market

Previous studies have investigated the determinants of housing price cycles in the housing market; however, we observed the phenomenon of housing price jumps in the 2007 subprime crisis. This paper presents a discussion on the housing price cycle and abnormal price jumps to describe the behavior of housing prices in the United Kingdom. The empirical results show that the impact factors of housing cycles are market risk and the switching factor. Furthermore, the impact factors of jump risks include the bursting of the housing bubble and financial crises. Therefore, in this paper, we employ the Markov switching model with jump risks to value the MI contracts and analyze the influences of housing price cycles, jump risks, risks of market interest rate, and the prepayment risks on MI premiums. The results of sensitivity analysis show that more volatile housing price index returns, as well as longer periods of higher volatility in housing prices, raise MI premiums. Moreover, the MI premium is positively related to the absolute value of the average jump amplitude and the shock frequency of abnormal events. There is the tradeoff between the market interest rate and the prepayment risk. The influences of market interest rate are different on MI premium with/without prepayment risks.     

Exchange rate and inflation risk premia in the EMU

This paper tests the effects of exchange rate and inflation risk factors on asset pricing in the European Union (EU) stock markets. This investigation was motivated by the results of Vassalou [J. Int. Money Finance, 2000, 19, 433–470] showing that both exchange rate and foreign inflation are generally priced in equity returns, and it studies the opportunity of evaluating the causality between these sources of risk after the elimination of the EU currency risks because of the adoption of the single currency. Our results show that both exchange rate and inflation risks are significantly priced in the pre- and post-euro periods. Moreover, the sizes of exchange rate and inflation risk premiums are economically significant in the pre- and post-euro periods. Futhermore, the UK and excluding-UK inflation risk premiums explain, in part, our evidence concerning a large EUR/GBP exchange rate risk premium and the existence of an economically significant domestic non-diversifiable risk after euro adoption. Hence overlooking inflation risk factors can produce an under/overestimation of the currency premiums and a miscalculation of the degree of integration of stock markets.     

Evidence of risk premiums in foreign currency futures markets

Weekly data for foreign currency futures prices are examinedfor evidence of risk premium. Covariance risks are measuredwith respect to the excess returns from benchmark portfoliosfor consumption and wealth. When the parameters representingthe prices of the covariance risks are held constant, no riskpremiums are detected. However, when these prices are allowedto vary with the conditional expected returns and variancesof the benchmark portfolios, possibly reflecting changing investmentopportunities, strong evidence of risk premiums is obtained.     

Tests of the foreign exchange risk premium using the expected second moments implied by option pricing

This paper utilizes the second moment expectations implied by currency option pricing to demonstrate that these expectations are systematically related to expected return differentials across assets denominated in different currencies. Because the measured deviations from uncovered interest rate parity are tied to variables which theory links to the risk premium, the results provide substantial evidence that a risk premium does indeed exist, as opposed to the alternative of a violation of rational expectations. However, like previous attempts, the data do not support an explicit mean-variance formulation of the risk premium.     

Testing asset pricing models with changing expectations and an unobservable market portfolio

When the assumption of constant risk premiums is relaxed, financial valuation models may be tested, and risk measures estimated without specifying a market index or state variables. This is accomplished by examining the behavior of conditional expected returns. The approach is developed using a single risk premium asset pricing model as an example and then extended to models with multiple risk premiums. The methodology is illustrated using daily return data on the common stocks of the Dow Jones 30. The tests indicate that these returns are consistent with a single, time-varying risk premium.     

Regime switching in the relationship between equity returns and short-term interest rates in the UK

This paper examines the relationship between UK equity returns and short-term interest rates using a two regime Markov-Switching EGARCH model. The results suggest one high-return, low variance regime within which the conditional variance of equity returns responds persistently but symmetrically to equity return innovations. In the other, low-mean, high variance, regime equity volatility responds asymmetrically and without persistence to shocks to equity returns. There is evidence of a regime dependent relationship between shorter maturity interest rate differentials and equity return volatility. Furthermore, there is evidence that events in the money markets influence the probability of transition across regimes.     

Valuation impact of currency crises: Evidence from the ADR market

This study analyzes American depository receipts (ADR) performance surrounding the outbreak of major currency crises during the past decade. By employing event-study methodologies and multifactor pricing models, we find that the outbreak of a currency crisis is accompanied by a negatively significant abnormal return for the corresponding ADRs, even after controlling for variations in exchange rates. We also find significant upward shifts in the exchange rate exposure of ADRs when the home currency is switched from a “pegging” to a “floating” exchange rate regime. In addition, ADR-originating firms with larger sizes, greater proportions of U.S. market activities, and greater market liquidity have relatively less negative abnormal returns (ARs) and less significant upward shifts in currency exposure, implying that such firms are relatively better hedged against currency crises.     

International asset pricing under segmentation and PPP deviations

We analyze the impact of both purchasing power parity (PPP) deviations and market segmentation on asset pricing and investor's portfolio holdings. The freely traded securities command a world market risk premium and an inflation risk premium. The securities that can be held by only a subset of investors command two additional premiums: a conditional market risk premium and a segflation risk premium. Our model is empirically supported with important implications for tests of international asset pricing.     

International asset returns and exchange rates

We present a consumption-based international asset-pricing model to study global equity premiums, the US riskfree rate and the cross section of international asset returns. The model entails idiosyncratic, country-specific consumption risk, which helps explain the magnitude of global equity premiums. It also features country-specific habit formation, which helps explain the level of the interest rate on the US short-term Treasury bills traded by domestic and international investors. We find that the model explains approximately 40–50% of the cross section of currency and equity premiums as well as expected returns from value and growth portfolios of at least a dozen countries. Changes in real exchange rates are responsible for explaining approximately half of the cross section of international asset returns.     

Exchange risk and universal returns: A test of international arbitrage pricing theory

According to the international arbitrage pricing theory (IAPT) posited by Solnik (1983), currency movements affect assets' factor loadings and associated risk premiums. Based on a novel universal return decomposition, we propose an empirical model to test this proposition and perform tests using U.S. stock returns in the period 1975–2008. Our results confirm that currency movements significantly affect the market betas of a large proportion of stocks. Further cross-sectional tests indicate that currency movements affecting the market factor are significantly priced in stock returns. Based on these and other findings, we conclude that Solnik's IAPT is supported. An important implication of our findings is that exchange rate risk can broadly affect stock returns through both factor loading and residual factor channels.