Equity Tail Risk and Currency Risk Premia
59 Pages Posted: 17 Jun 2019 Last revised: 4 Aug 2020
Date Written: November 19, 2019
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: Suggested Citation