Uncertainty, Currency Excess Returns, and Risk Reversals

36 Pages Posted: 24 Feb 2017

See all articles by Lucas Husted

Lucas Husted

Board of Governors of the Federal Reserve System

John H. Rogers

Board of Governors of the Federal Reserve System - Trade and Financial Studies Section

Bo Sun

Board of Governors of the Federal Reserve System - Division of International Finance

Date Written: 2017-02

Abstract

In this paper we provide strong evidence that heightened uncertainty in the U.S. real economy or financial markets significantly raises excess returns to the currency carry trade. We posit that this works through the influence of uncertainty on global investors' risk preferences. Macro and financial uncertainty also lower foreign exchange risk reversals, an effect that is particularly strong for high interest rate portfolios. Our results are consistent with the idea that an increase in uncertainty regarding the U.S. economy or financial markets increases investors' risk aversion, which in turn drives up the expected returns and the cost of protection against crash risk in the FX market.

Keywords: Exchange rates, Uncovered interest parity, Uncertainty

JEL Classification: F41

Suggested Citation

Husted, Lucas and Rogers, John H. and Sun, Bo, Uncertainty, Currency Excess Returns, and Risk Reversals (2017-02). FRB International Finance Discussion Paper No. 1196. Available at SSRN: https://ssrn.com/abstract=2923010 or http://dx.doi.org/10.17016/IFDP.2017.1196

Lucas Husted

Board of Governors of the Federal Reserve System

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

John H. Rogers (Contact Author)

Board of Governors of the Federal Reserve System - Trade and Financial Studies Section ( email )

20th St. and Constitution Ave.
Washington, DC 20551
United States
202-452-2873 (Phone)
202-736-5638 (Fax)

Bo Sun

Board of Governors of the Federal Reserve System - Division of International Finance ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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