Crash Risk in Currency Returns

70 Pages Posted: 16 Mar 2012 Last revised: 3 Apr 2015

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: June 13, 2014

Abstract

We quantify crash risk in currency returns. To accomplish this task, 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) normal 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 an upward (downward) jump in the exchange rate, associated with depreciation (appreciation) of the US dollar, 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. On average, jumps account for 25% (and can be as high as 40%) of total currency risk, as measured by the entropy of exchange rate changes, over horizons of one to three months. Preliminary analysis suggests that these properties of currency returns correspond to observed option smiles and that jump risk is priced.

Keywords: currency speculation, crashes, jumps, entropy, Bayesian MCMC

JEL Classification: G13, F31, C11

Suggested Citation

Chernov, Mikhail and Graveline, Jeremy J. and Zviadadze, Irina, Crash Risk in Currency Returns (June 13, 2014). Available at SSRN: https://ssrn.com/abstract=2023440 or http://dx.doi.org/10.2139/ssrn.2023440

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

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