Pricing Risks across Currency Denominations

74 Pages Posted: 5 Apr 2015 Last revised: 6 Sep 2018

See all articles by Thomas Andreas Maurer

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

Pamplin College of Business - Virginia Tech

Date Written: July 26, 2016

Abstract

We use principal component analysis on 55 bilateral exchange rates of 11 developed currencies to identify two important global risk sources in FX markets. The risk sources are related to Carry and Dollar but are not spanned by these factors. We estimate the market prices associated with the two risk sources in the cross-section of FX market returns and construct FX market implied country-specific SDFs. The SDF volatilities are related to interest rates and expected carry trade returns in the cross-section. The SDFs price international stock returns and are related to important financial stress indicators and macroeconomic fundamentals. The first principal risk is associated with the TED spread, quantities measuring volatility, tail and contagion risks and future economic growth. It earns a relatively small implied Sharpe ratio. The second principal risk is associated with the default and term spreads and quantities capturing volatility and illiquidity risks. It further correlates with future changes in the long term interest rate and earns a large implied Sharpe ratio.

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

Pamplin College of Business - Virginia Tech ( email )

Pamplin 2126
880 West Campus Drive
Blacksburg, VA 24061
United States

HOME PAGE: http://https://www.nktran.com/

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