Long Run and Short Run Risk Premium in Currency Market

41 Pages Posted: 21 Aug 2019

Date Written: July 27, 2019

Abstract

In this paper, I investigate risk premium of long run and short run volatility component of exchange rate returns in currency market. I find that high interest rate currencies of carry trade strategy load negatively on long run volatility innovation, while low interest rate currencies load positively. Risk price of long run volatility innovation is negative which implies that high carry trade returns are considered as compensation for time varying long run volatility risk. In contrast, risk price of short run volatility innovation is positive. Low interest currencies deliver low returns and high interest rate currencies yield high returns under times of high short run volatility. In terms of momentum strategy, risk price of short run volatility innovation is negative and statistically significant, while risk price of long run component is insignificant. Therefore, long run volatility does not provide any explanation for high returns of currency momentum strategy. High momentum returns, on the other hand are reward for investors to bear short run volatility risk.

Keywords: volatility, exchange rate, carry trade, momentum, risk premium

JEL Classification: F31, G11, G12

Suggested Citation

Hoang, Duc Hong, Long Run and Short Run Risk Premium in Currency Market (July 27, 2019). Available at SSRN: https://ssrn.com/abstract=3439109 or http://dx.doi.org/10.2139/ssrn.3439109

Duc Hong Hoang (Contact Author)

Lund University ( email )

Box 117
Lund, SC Skane S221 00
Sweden

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