Semivariance and Semiskew Risk Premiums in Currency Markets

53 Pages Posted: 27 Jan 2018 Last revised: 25 Aug 2018

See all articles by José Da Fonseca

José Da Fonseca

Auckland University of Technology - Faculty of Business & Law

Edem Dawui

World Bank

Date Written: August 24, 2018

Abstract

Using the model-free methodology proposed in the literature, variance and skew swaps are extracted from currency options for several foreign exchange rates. Moreover, these variables are decomposed into semivariance and semiskew swaps, which are conditional to the evolution of the foreign exchange rate, and it is shown to have higher explanatory power for currency excess return. These semivariances enable the definition of a variance-skew swap that also possesses a strong explanatory power for currency excess return. From these variables, higher moment semi-risk premiums can be computed and measure how tail risks are priced. These semivariance and semiskew swaps better explain the currency excess return than the standard or undecomposed ones. For semivariance swaps, both the up and down contracts are equally informative while for semiskew swaps only the down tail related one is. Down semivariance and semiskew swaps carry complementary information regarding the currency excess return. Trimming these variables enables us to show that extreme movements affecting the currency option market contain no information on the evolution of the currency. Lastly, forecasting tests further illustrate the importance of decomposing the variance and skew swaps into semi components as it improves significantly the results.

Keywords: Variance risk premium, Skew risk premium, Semi-measures, Currency risk premium

JEL Classification: G11, G12, G13

Suggested Citation

Da Fonseca, José and Dawui, Edem, Semivariance and Semiskew Risk Premiums in Currency Markets (August 24, 2018). Asian Finance Association (AsianFA) 2018 Conference. Available at SSRN: https://ssrn.com/abstract=3110019 or http://dx.doi.org/10.2139/ssrn.3110019

José Da Fonseca (Contact Author)

Auckland University of Technology - Faculty of Business & Law ( email )

3 Wakefield Street
Private Bag 92006
Auckland Central 1020
New Zealand
64 9 921 9999 5063 (Phone)

Edem Dawui

World Bank ( email )

1818 H Street, NW
Washington, DC 20433
United States

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