Global Currency Misalignments, Crash Sensitivity, and Moment Risk Premia

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