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Pricing Risks across Currency Denominations

67 Pages Posted: 5 Apr 2015 Last revised: 27 Jul 2016

Thomas Andreas Maurer

Washington University in St. Louis - John M. Olin Business School; London School of Economics & Political Science (LSE)

Thuy Duong To

University of New South Wales, Sydney; Financial Research Network (FIRN)

Ngoc-Khanh Tran

Washington University in Saint Louis - John M. Olin Business School

Date Written: July 26, 2016

Abstract

We document a novel empirical regularity that investors in low interest rate countries earn substantially higher Sharpe ratios on identical carry trade strategies than investors in high interest rate countries. We further document that bilateral exchange rate volatilities are increasing in interest rate differentials between currencies. These observations place new important restrictions on no-arbitrage models of international asset pricing. Our analysis naturally gives rise to a new non-parametric procedure to estimate country-specific stochastic discount factors (SDFs) from exchange rate data. In support of our approach, out-of-sample, the estimated SDFs sort linearly with national output gap fluctuations, and price risks in international equity markets.

Keywords: Currency risks, carry trades, stochastic discount factor, principal components

JEL Classification: F31, G15

Suggested Citation

Maurer, Thomas Andreas and To, Thuy Duong and Tran, Ngoc-Khanh, Pricing Risks across Currency Denominations (July 26, 2016). UNSW Business School Research Paper No. 2015 BFIN 06; FIRN Research Paper No. 2589545. Available at SSRN: https://ssrn.com/abstract=2589545 or http://dx.doi.org/10.2139/ssrn.2589545

Thomas Andreas Maurer (Contact Author)

Washington University in St. Louis - John M. Olin Business School ( email )

One Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States

London School of Economics & Political Science (LSE) ( email )

Houghton Street
London, WC2A 2AE
United Kingdom

Thuy Duong To

University of New South Wales, Sydney ( email )

School of Banking and Finance,
University of New South Wales
Sydney, 2052
Australia
61295855865 (Phone)

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

Ngoc-Khanh Tran

Washington University in Saint Louis - John M. Olin Business School ( email )

One Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States

HOME PAGE: http://www.olin.wustl.edu/EN-US/Faculty-Research/Faculty/Pages/FacultyDetail.aspx?username=ntran

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