From carry trades to curvy trades

Traditional carry trade strategies are based on differences in short-term interest rates, neglecting any other information embedded in yield curves. We derive return distributions of currency portfolios, where the signals to buy and sell currencies are based on summary measures of the yield curve. We find that a strategy based on the relative curvature factor, the curvy trade, yields higher Sharpe ratios and a smaller return skewness than traditional carry strategies. Curvy trades build less upon the typical carry currencies and are hence less susceptible to crash risk. In line with that, standard pricing factors of traditional carry returns fail to explain curvy trade returns.     

The relevance of currency risk in the EMU

We investigate how the elimination of intra-European exchange risk may affect international financial markets using a conditional version of the International CAPM. We estimate the EMU and non-EMU components of aggregate currency risk and document significant exposures to both. The premium for EMU risk is positive and associated with exposure to the French, Italian and Spanish currencies. The premium for non-EMU risk is consistently negative and accounts for most of the aggregate currency premiums. In the 1990s, exposures to EMU risk declined significantly while exposures to non-EMU risk increased. Hence the adoption of the Euro is unlikely to have a large impact on aggregate currency risk premiums.     

Optimal Currency Composition for China's Foreign Reserves: A Copula Approach

This paper investigates the optimal currency composition for a country's foreign reserves. In the context of China, we examine the asymmetric, fat‐tail and complex dependence structure in distributions of currency returns. A skewed, fat‐tailed and pair‐copula construction is then built to capture features of higher moments. In a D‐vine copula approach, we show that under the disappointment aversion effect, the central bank in our model can achieve sizeable gains in expected economic value from switching from the mean‐variance to copula modelling. We find that this approach will lead to an optimal currency composition that allows China to have more space for international currency diversification while maintaining the leading position of the US dollar in the currency shares of China's reserves.     

Hedging costs and joint determinants of premiums and spreads in structured financial products

Evaluating more than 317,000 discount certificates in the German secondary market, we find that premiums and spreads are endogenous and negatively related but depend on different key determinants. The fundamental determinants of the premiums are mainly profit-related, that is, dividends of the underlying, issuers’ credit risk, lifecycle effect, and competition, whereas hedging costs are less important. However, initial hedging costs (IHC) are priced into the premium in the case of large inventory changes. The spread is mostly determined by hedging costs and risk components, such as IHCs, rebalancing costs, volatility, scalper risk, and overnight gap risk—but also by dividends.     

The long or short of it: Determinants of foreign currency exposure in external balance sheets

A major focus of the recent literature on the determination of optimal portfolios in open-economy macroeconomic models has been on the role of currency movements in determining portfolio returns that may hedge various macroeconomic shocks. However, there is little empirical evidence on the foreign currency exposures that are embedded in international balance sheets. Using a new database, we provide stylized facts concerning the cross-country and time-series variation in aggregate foreign currency exposure and its various subcomponents. In panel estimation, we find that richer, more open economies take longer foreign-currency positions. In addition, we find that an increase in the propensity for a currency to depreciate during bad times is associated with a longer position in foreign currencies, providing a hedge against domestic output fluctuations. We view these new stylized facts as informative in their own right and also potentially useful to the burgeoning theoretical literature on the macroeconomics of international portfolios.     

Valuation of housing index derivatives

This study analyzes the valuation of housing index derivatives traded on the Chicago Mercantile Exchange (CME). Specifically, to circumvent the nontradability of housing indices, we propose and implement an equilibrium valuation framework. Assuming a mean-reverting aggregate dividend process and a utility function characterized by constant relative risk aversion, we show that the value of a housing index derivative depends only on parameters characterizing the underlying housing index, the endogenized interest rate and their correlation. We also analytically and numerically examine risk premiums for the CME futures and options and obtain three important findings. First, risk premiums are significant for all contracts with maturities longer than one year. Second, the expected growth rate of the underlying index is the key determinant for risk premiums. Third, risk premiums can be positive or negative, depending on whether the expected growth rate of the underlying index is higher or lower than the risk-free yield-to-maturity. © 2009 Wiley Periodicals, Inc. Jrl Fut Mark 30:660–688, 2010     

Examining Determinants of Foreign Wage Premiums in China

We estimate foreign wage premiums for every 3‐digit manufacturing industry in China and discover a wide range of premiums both for ‘foreign’ ownership and for overseas Chinese ownership. Foreign ownership generates larger and more prevalent wage premiums than overseas Chinese ownership, but both produce premiums that respond similarly in estimates of determinants. Using the number of computers per worker to measure firms' technology levels, we find evidence consistent with the hypothesis that foreign firms pay higher wages to reduce the risk of worker turnover and the accompanying technology leakage in 76 to 78 per cent of industries. However, this determinant explains only 5 to 6 per cent of the foreign wage premium. We find the most intensive support for the ‘fair wage’ hypothesis that foreign firms pay higher wages because they are more profitable than domestic firms and workers in more profitable firms expect to be paid more, otherwise they will shirk. This hypothesis explains an average of 8 to 9 per cent of the foreign wage premiums, with support found in 72 to 75 per cent of the industries. When we consider the best combination of explanatory variables to include in each industry's wage regression, we find evidence consistent with our combined hypotheses in most industries, but we still find large residual foreign wage premiums.     

Information Technology and Consumer Search for Health Insurance

We explore the impact of information technology on the level of premiums paid for individual health insurance by asking which kinds of buyers will have larger gains from the use of new technology. We compare ‘asking price’ data posted on an electronic insurance exchange with survey data on premiums actually paid before the advent of exchange and examine whether the pattern of differences between asking prices and transactions prices can be explained using a simple search theory. We hypothesize that older consumers, expecting to pay higher premiums for a given policy, had engaged in more intensive search than younger consumers, given the same distribution of prices and search costs. Therefore, the introduction of an electronic exchange that lowers the cost of search should have a larger effect on decreasing the level of premiums paid for those who previously searched less (i.e., younger consumers). We find evidence consistent with this hypothesis.     

Examining the Return–Volatility Relation for Foreign Exchange: Evidence from the Euro VIX

We compare the return–volatility relation for the euro currency to the equivalent relation for the equity market, examining the sign, symmetry, and strength of the relation. We employ the euro‐currency exchange‐traded fund (FXE) and its associated option implied volatility index (the EVZ), whereas previous studies only employ equities and/or realized volatility. The equity studies find a negative asymmetric return–volatility relation for implied volatility, with a strong relation when large market movements occur. We find that the euro return–volatility relation can possess either a positive or negative sign, is asymmetric, and has a weaker relation. Thus, the sign and strength of the euro relation differs from the equivalent equity relation. Our quantile regressions show that both the positive and negative contemporaneous returns of the euro result in increased volatility in the extreme quantiles of the conditional distribution, with the contemporaneous effect showing a stronger relation when the euro depreciates. We also find that the volume of the euro‐currency ETF options affects the return–volatility relation for the euro ETF. Overall, the results here expand the concept originally restricted to equities, with the surprising results that the return‐implied volatility relation is weaker and the asymmetric return sometimes is positive for the euro currency. © 2012 Wiley Periodicals, Inc. Jrl Fut Mark 34:74–92, 2014     

Variance and skew risk premiums for the volatility market: The VIX evidence

We extract variance and skew risk premiums from volatility derivatives in a model-free way and analyze their relationships along with volatility index and equity index returns. These risk premiums can be synthesized through option trading strategies. Using a time series of option prices on the VIX, we find that variance swap excess return can be partially explained by volatility index and equity index excess returns while these latter variables carry little information for the skew swap excess return. The results sharply contrast with those obtained for the equity index option market underlining very specific characteristics of the volatility derivative market.     

International trade and child labor: Cross-country evidence

We explore the relationship between exposure to trade (as measured by openness) and child labor in a cross-country setting. Our methodology accounts for the fact that trade flows are endogenous to child labor (and labor standards more generally) by examining the relationship between child labor and variation in trade based on geography. We find that countries that trade more have less child labor. At the cross-country means, the data suggest an openness elasticity of child labor of − 0.7. For low-income countries, the elasticity of child labor with respect to trade with high-income countries is − 0.9. However, these relationships appear to be largely attributable to the positive association between trade and income. We consistently find a small and statistically insignificant association between openness and child labor when we control for cross-country income differences in the full sample, when we split the sample into different country groups, consider only trade between high- and low-income countries, or focus on exports of unskilled-labor intensive products from low-income countries. Thus, the cross-country data do not substantiate assertions that trade per se plays a significant role in perpetuating the high levels of child labor that pervade low-income countries.     

The carry trade and fundamentals: Nothing to fear but FEER itself

Risky arbitraging based on interest rate differentials between two countries is typically referred to as a carry trade. Up until the recent global financial crisis, these trades generated years of persistent positive returns, which were hard to reconcile with standard pricing kernels. In 2008 these trades blew up, which seemed to weaken the case for a puzzle relating to predictable currency returns. But the rise and fall of this puzzle in the academic literature has only been concerned with naïve carry trades based on yield signals alone. We show, however, that some simple and more realistic fundamentals-augmented trading strategies would have generated strong and sustained positive profits that endured through the turmoil.     

China's segmented stock market: An application of the conditional international capital asset pricing model

China's segmented stock market provides an opportunity to study conditional international asset pricing from multiple viewpoints—domestic and foreign. We use the multivariate GARCH-M framework of De Santis and Gérard [De Santis, G., and Gérard, B., 1998. How big is the premium for currency risk? Journal of Financial Economics 49, pp. 375–412.], but add conditional local specific risk and find global, local, and currency risk to be priced and time-varying in Chinese markets, suggesting mild segmentation for developing country markets. The time-varying price of currency risk indicates that the strict currency restrictions in China do not sufficiently reduce currency risk to stabilize the price of currency risk. We also find that the price of local risk in the Chinese A stock market is non-time-varying relative to the developed market, but time-varying relative to the emerging market. This finding implies that the Chinese A stock market is more comparable to a developed market than an emerging market. However, results on Chinese B shares show the opposite relationship: from a foreign investor's perspective, Chinese B shares are better categorized as being emerging than developed. This is further supported by an Engle–Granger cointegration test.     

Real earnings management and the cost of new corporate bonds

We examine the association between real earnings management and the cost of new bond issues of U.S. corporations. We consider three types of real earnings management: sales manipulation, overproduction, and the abnormal reduction of discretionary expenditures. We find that overproduction impairs credit ratings and that sales manipulation and overproduction are associated with higher bond yield spreads. Overall, our results imply that credit rating agencies and bondholders perceive real earnings management as a credit risk-increasing factor and thus require high risk premiums.     

One Market,One Money: Evidence from Canada–United States Economic Integration

In this paper, we focus on the evolution of the optimum currency area (OCA) properties between Canada and the United States. To this end, we specifically investigate the relationship between the intra‐industry trade dynamics of Canadian provinces with the United States and the increasing level of integration between the two countries from 1980 to 1998. Our findings lead us to support the view that integration (real and monetary) improves the conditions under which a monetary union can yield net gains in the long run for the integrating countries. We also find that exchange rate developments exert asymmetric effects on the Canadian provinces.     

Debt composition and balance sheet effects of exchange rate volatility in Mexico: a firm level analysis

We use Mexican firm-level data to study the role of currency mismatches in the corporate sector in exacerbating the negative effects of a devaluation. We also investigate what drives Mexican firms to borrow in foreign currency. We find that holding dollar denominated debt in a devaluation adversely affects firms’ earnings and investment. However, exporters invested more than non-exporters in the same period. We also find that the negative effect of dollar debt was stronger than the positive effect of exports in the 1994 crisis for firms with positive dollar debt and/or exports, relative to firms that did not borrow abroad and/or export. This was a result of imperfect currency matching by firms. However, in the 1998 crisis firms managed the denominations of their inflows and outflows much better and these two effects were roughly equal in magnitude. We also find some evidence of currency matching by exporters, especially after the introduction of the floating exchange rate.     

Currency risk and microcredit interest rates

Foreign currency debt provides additional access to capital and offers funds in favorable and flexible terms to microfinance institutions (MFIs). Yet, we find that the use of foreign currency debt, on average, leads to higher microcredit interest rates. We also find that MFIs operating in countries with pegged exchange rate regimes and profit MFIs are better able to mitigate foreign currency risk. The results of the paper suggest that local currency debt is a better option for MFIs if the goal is to provide microcredit at lower interest rates.     

The tail risk of emerging stock markets

We investigate tail risk in emerging stock markets at the country, regional and world levels, by comparing the investable and non-investable segments in terms of the expected shortfall of standardized returns and tail dependence on the world market. Employing the skewed Student-t GJR-GARCH model and the SJC copula, we show that most investable portfolios have lower tail risk but higher tail dependence than non-investable ones; emerging markets are likely more dependent on the world market during large joint losses than large joint gains; and tail dependence of the aggregate and investable markets on the world market varies across countries and regions.     

Time‐varying market price of risk in the crude oil futures market

In this study, a three‐factor model of crude oil prices is estimated, which incorporates a time‐varying market price of risk. The model is able to accurately capture the term structure of futures prices with evidence suggesting that risk premiums in the crude oil market are time‐varying. Using the cross‐section of futures prices, we estimate a time‐series of the market price of risk in the crude oil market implied by the model. We find that the risk premiums in the crude oil market are driven by the same risk factors as equity and bond markets. © 2010 Wiley Periodicals, Inc. Jrl Fut Mark 31:779–807, 2011     

The risk effects of combining banking, securities, and insurance activities

We create synthetic universal banks to examine the impact of securities and insurance activities on the banking firms’ risk. We find that these nonbank activities reduce the overall risk to the firm but increase systematic market risk—thus reducing the firm’s ability to diversify. Moreover, the unit price of risk does not appear to contain a risk premium to price the enhanced systemic risk exposure that might be engendered by greater convergence across financial firms. Our finding suggests that if there are net gains to universal banking, potential gains from synergies and demand effects must be powerful enough to overcome the disadvantages of increased systemic risk exposure. The results suggest that diversification benefits, when considered in isolation from the other implications of expanded bank powers, are not sufficiently large to justify expanding bank powers into nonbank securities and insurance underwriting activities.