Global Currency Misalignments, Crash Sensitivity, and Moment Risk Premia

2015 American Economic Association Annual Meeting; Boston, MA, US.

2015 Royal Economic Society Annual Meeting; Manchester, UK.

70 Pages Posted: 15 Feb 2014 Last revised: 22 Jun 2016

See all articles by Huichou Huang

Huichou Huang

City University of Hong Kong

Ronald MacDonald

University of Glasgow - Adam Smith Business School

Date Written: April 23, 2015

Abstract

In this paper we investigate 3 important properties of global currencies: misalignments measured by the deviations from equilibrium (real effective) exchange rates, crash sensitivity captured by the copula tail dependence to the global market, and moment risk premia using a model-free method -- volatility risk premia as the proxy for (relative) position insurance costs, and skew risk premia as the gauge for (carry trade) speculative inclinations. The overvalued (undervalued) currencies with respect to REER tend to be crash sensitive (insensitive) and relatively cheap (expensive) to hedge, and exhibit high (low) speculative risk premia. We further show that they have rich asset pricing and allocation implications. The profitability of currency carry trades can be understood as the compensation for misalignment and speculative risks, which explain over 96% of the cross-sectional excess returns and dominate other candidate factors, including sovereign credit and liquidity risks, and cover the information of volatility risk. Currency trading strategies exploiting these 3 properties provide striking crash-neutral and diversification benefits for portfolio optimization and risk management purposes. After examining the risk attributes and factor structure of 7 studied currency investment strategies and of over 30 individual currencies using generalized dynamic factor model, we identify an additional important factor which is related to hedging demand imbalances, also priced in the cross section of currency value portfolios (over 90% of the variations) and of global currencies (14% extra variations), but it is omitted in literature using standard portfolio approach.

Keywords: Exchange Rate Misalignments, Copula, Tail Dependence, Moment Risk Premia, Currency Investment Management

JEL Classification: F31, F37, G01, G12, G17

Suggested Citation

Huang, Huichou and MacDonald, Ronald, Global Currency Misalignments, Crash Sensitivity, and Moment Risk Premia (April 23, 2015). 2015 Royal Economic Society Annual Meeting; Manchester, UK.. Available at SSRN: https://ssrn.com/abstract=2393105 or http://dx.doi.org/10.2139/ssrn.2393105

Huichou Huang (Contact Author)

City University of Hong Kong

Global Research Unit (GRU), College of Business
Department of Economics & Finanace
Hong Kong
China

Ronald MacDonald

University of Glasgow - Adam Smith Business School ( email )

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