Central Bank Tone and Currency Risk Premia
42 Pages Posted: 5 Jan 2019 Last revised: 7 Mar 2019
Date Written: March 6, 2019
I analyze how the tone of central bank press conferences impacts risk premia in the currency market. I measure tone as the difference between the number of hawkish and dovish phrases made during a press conference. I consider two measures of risk premia. The first measure is implied risk aversion. This is based on the relationship between the option implied, or risk neutral distribution of returns, and the physical, or actual distribution of returns. I find that implied risk aversion increases when central banks are hawkish, and decreases when central banks are dovish. The second measure is the variance risk premium. This is the difference between option implied and realized variance, and reflects the cost of insuring against an unexpected increase in variance. I find that variance risk premia increase when central banks are hawkish, and decrease when central banks are dovish. The magnitudes are economically and statistically significant. A one standard deviation increase in the hawkishness of a press conference increases implied risk aversion by 1.4%, and increases the one month variance risk premium by 4.1% per year, relative to the average of 28.8% per year.
Keywords: Monetary Policy, Risk Aversion, Exchange Rates
JEL Classification: G15, E5
Suggested Citation: Suggested Citation