US Equity Tail Risk and Currency Risk Premia

Zhenzhen Fan, Juan M. Londono and Xiao Xiao

No 1253, International Finance Discussion Papers from Board of Governors of the Federal Reserve System (U.S.)

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 (search for similar items in EconPapers)
JEL-codes: F31 G12 G15 (search for similar items in EconPapers)
Pages: 51
Date: 2019-07-08
New Economics Papers: this item is included in nep-fmk and nep-rmg
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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedgif:1253

DOI: 10.17016/IFDP.2019.1253

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