US Equity Tail Risk and Currency Risk Premia

53 Pages Posted: 17 Jun 2019

See all articles by Zhenzhen Fan

Zhenzhen Fan

School of Finance, Nankai University

Juan M. Londono

Federal Reserve Board of Governors

Xiao Xiao

Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE); Erasmus Research Institute of Management (ERIM)

Date Written: April 6, 2019

Abstract

We find that a US equity tail risk factor constructed from out-of-the-money S&P 500 put option prices explains the cross-sectional variation of currency excess returns. Currencies highly exposed to this factor offer a low currency risk premium because they appreciate when US tail risk increases. In a reduced-form model, we show that country-specific tail risk factors are priced in the cross section of currency returns only if they contain a global risk component. Motivated by the intuition from the model and by our empirical results, we construct a novel proxy for a global tail risk factor by buying currencies with high US equity tail beta and shorting currencies with low US tail beta. This factor, along with the dollar risk factor, explains a large portion of the cross-sectional variation in the currency carry and momentum portfolios and outperforms other models widely used in the literature.

Keywords: Equity tail risk; Global 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, US Equity Tail Risk and Currency Risk Premia (April 6, 2019). Available at SSRN: https://ssrn.com/abstract=3399980 or http://dx.doi.org/10.2139/ssrn.3399980

Zhenzhen Fan

School of Finance, Nankai University ( email )

38 Tongyan Road, Jinnan District
Tianjin, Tianjin 300350
China

Juan-Miguel Londono-Yarce

Federal Reserve Board of Governors ( email )

20th St. and Constitution Ave.
Washington, DC 20551
United States

Xiao Xiao (Contact Author)

Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE) ( email )

P.O. Box 1738
3000 DR Rotterdam, NL 3062 PA
Netherlands

Erasmus Research Institute of Management (ERIM) ( email )

P.O. Box 1738
3000 DR Rotterdam
Netherlands

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