Equity Tail Risk and Currency Risk Premia

59 Pages Posted: 17 Jun 2019 Last revised: 4 Aug 2020

See all articles by Zhenzhen Fan

Zhenzhen Fan

University of Manitoba - Department of Accounting and Finance

Juan M. Londono

Board of Governors of the Federal Reserve System

Xiao Xiao

University of Amsterdam - Amsterdam Business School

Date Written: November 19, 2019

Abstract

We find that an option-based equity tail risk factor is priced in the cross section of currency returns. Currencies highly exposed to this factor offer a low risk premium because they hedge against equity tail risk. In a reduced-form model, we show that a long-short portfolio that buys currencies with high equity tail beta and shorts those with low tail beta extracts the global component embedded in the tail risk factor. Inspired by the model, we construct a novel global tail risk factor from currency returns. The estimated price of risk of this global factor is consistently negative and of similar magnitude in various currency portfolios including carry and momentum, suggesting that the excess returns of these strategies can be partially understood as compensations for global tail risk.

Keywords: Global tail risk; Option-implied equity tail risk; Currency returns; Carry trade; Currency momentum

JEL Classification: G12, G15, F31

Suggested Citation

Fan, Zhenzhen and Londono-Yarce, Juan-Miguel and Xiao, Xiao, Equity Tail Risk and Currency Risk Premia (November 19, 2019). Available at SSRN: https://ssrn.com/abstract=3399980 or http://dx.doi.org/10.2139/ssrn.3399980

Zhenzhen Fan

University of Manitoba - Department of Accounting and Finance ( email )

Faculty of Management
Winnipeg, MB R3T 5V4
Canada

Juan-Miguel Londono-Yarce

Board of Governors of the Federal Reserve System ( email )

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

Xiao Xiao (Contact Author)

University of Amsterdam - Amsterdam Business School ( email )

Spui 21
Amsterdam, 1018 WB
Netherlands

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