Sources of Risk in Currency Returns

53 Pages Posted: 20 Jan 2012

See all articles by Mikhail Chernov

Mikhail Chernov

UCLA Anderson

Jeremy J. Graveline

University of Minnesota - Carlson School of Management

Irina Zviadadze

Stockholm School of Economics; Swedish House of Finance; Centre for Economic Policy Research (CEPR)

Date Written: January 2012

Abstract

We quantify the sources of risk in currency returns as a first step toward understanding the returns reported for the carry trade. To do this, we develop and estimate an empirical model of exchange rate dynamics using daily data for four currencies relative to the US dollar: the Australian dollar, the British pound, the Swiss franc, and the Japanese yen. The model includes (i) Gaussian shocks with stochastic variance, (ii) jumps up and down in the exchange rate, and (iii) jumps in the variance. We identify these components using data on exchange rates and at-the-money implied variances. We find that the probability of a jump depreciation (appreciation) in the exchange rate is increasing in the domestic (foreign) interest rate. The probability of jumps in variance is increasing in the variance but not related to interest rates. Many of the jumps in exchange rates are associated with macroeconomic and political news, but jumps in variance are not. Overall, jumps account for 25% of total currency risk over horizons of one to three months.

Keywords: Bayesian MCMC, carry trades, exchange rates, implied volatility, jumps

JEL Classification: C58, F31, G12

Suggested Citation

Chernov, Mikhail and Graveline, Jeremy J. and Zviadadze, Irina, Sources of Risk in Currency Returns (January 2012). CEPR Discussion Paper No. DP8745, Available at SSRN: https://ssrn.com/abstract=1988677

Mikhail Chernov (Contact Author)

UCLA Anderson ( email )

110 Westwood Plaza
Los Angeles, CA 90095-1481
United States

Jeremy J. Graveline

University of Minnesota - Carlson School of Management ( email )

19th Avenue South
Minneapolis, MN 55455
United States
612-626-7817 (Phone)

HOME PAGE: http://www.tc.umn.edu/~jeremy/

Irina Zviadadze

Stockholm School of Economics ( email )

PO Box 6501
Stockholm, 11383
Sweden

Swedish House of Finance ( email )

Drottninggatan 98
111 60 Stockholm
Sweden

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Here is the Coronavirus
related research on SSRN

Paper statistics

Downloads
8
Abstract Views
1,069
PlumX Metrics