The Skewness Risk Premium in Currency Markets

Journal of Economic Modelling, 2016

59 Pages Posted: 19 Feb 2016 Last revised: 20 Oct 2016

See all articles by Michael Broll

Michael Broll

University of Duisburg-Essen - Department of Economics and Business Administration

Date Written: October 10, 2016

Abstract

This paper examines the relationship between currency option’s implied skewness and its future realized skewness, where the difference is known as the skewness risk premium (SRP). The SRP indicates whether investors pay a premium to be insured against future crash risk. Past investigations about implied and realized skewness within currency markets showed that both measures are loosely connected or even exhibit a negative relationship that cannot be rationalized by no-arbitrage arguments. Therefore, this paper studies time-series of future and option contract positions data in order to explain the disconnection in terms of investor’s position-induced demand pressure. While demand pressures on options do not sufficiently contribute to the disconnection, there is evidence that, surprisingly, demand pressure in currency future markets have the power to explain this market anomaly. Furthermore, currency momentum also plays an important role, which leads to a strong cyclical demand for OTM calls in rising or OTM puts in declining markets. In order to exploit the disconnection of skewness, a simple skew swap trading strategy proposed by Schneider (2012) has been set up. The resulting skew swap returns are relatively high, but the return distribution is extremely fat-tailed. To appropriately compare different skew swap strategy returns, this paper proposes a Higher Moment Sharpe Ratio that also takes higher moments into account.

Keywords: skewness risk, Sharpe ratio, currency market risk, implied moments, skew swap

JEL Classification: C13, C21, C32, C87, F31, G13, G15

Suggested Citation

Broll, Michael, The Skewness Risk Premium in Currency Markets (October 10, 2016). Journal of Economic Modelling, 2016. Available at SSRN: https://ssrn.com/abstract=2734715 or http://dx.doi.org/10.2139/ssrn.2734715

Michael Broll (Contact Author)

University of Duisburg-Essen - Department of Economics and Business Administration ( email )

Universitätsstr. 9
Essen, 45141
Germany

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