Global Currency Misalignments, Crash Sensitivity, and Downside Insurance Costs

Huang, Huichou; MacDonald, Ronald; Zhao, Yang

doi:10.2139/ssrn.2393105

Cited by 3 publications

(5 citation statements)

References 165 publications

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“…This approach has the tendency to under estimate the sensitivity. It also means that the correlation or regression beta analysis does not accurately measure the dependence structure between currencies (Huang et al, 2014), especially when this structure is changed due to the occurrence of extreme returns that result from higher exchange rate volatility. Hence, currency tail risk must be considered in examining the dependence structure between currencies.…”

Section: Introductionmentioning

confidence: 99%

Impact of Chinese Yuan Devaluation on the Dependence Structure: The Archimedean Copula Approach

Lai

Goh

2019

Rev. Pac. Basin Finan. Mark. Pol.

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This paper investigates the linkages of Chinese yuan to other currencies before and after the yuan devaluation on 11 August 2015. Linear regression analysis shows that only a few of the 14 currencies considered are significantly affected by the devaluation. However, the devaluation of Chinese yuan has been associated with larger fluctuations in these currencies and the occurrence of extreme positive and negative returns. The regression method may under estimate the tail dependence between currencies, as financial data are usually non-normally distributed, especially when extreme event occurs. We apply the Archimedean copulas to capture the presence of lower and upper tail dependence between the exchange rate returns of Chinese yuan and the selected currencies, and found dependencies not revealed by the linear regression analysis. The extreme returns after the Chinese yuan devaluation have resulted in higher dependence with the selected currencies. While the dependence structure was dominated by risks due to unusual currency gains before the devaluation, the market responses to large losses and gains have become more symmetric after the devaluation.

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Section: Introductionmentioning

confidence: 99%

Impact of Chinese Yuan Devaluation on the Dependence Structure: The Archimedean Copula Approach

Lai

Goh

2019

Rev. Pac. Basin Finan. Mark. Pol.

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“…Specifically, the volatility risk premium (V RP t ) as a measure of hedging demand imbalances (Garleanu, Pedersen, and Poteshman, 2009), and hence can be interpreted as a proxy for (relative) downside insurance cost (Della Corte, Ramadorai, and Sarno, 2013). According to Huang and MacDonald (2013), the skew risk premium (SRP t ) measures the expected change in the probability of UIP to hold, and therefore can be interpreted as a proxy for crash risk premia of investment currencies relative to funding currencies, and the kurtosis risk premium (KRP t ) naturally reflects tail risk premium. The formula for moment risk premia is given by:…”

Section: Scapegoat Variablesmentioning

confidence: 99%

“…is the inverse function of continuous marginal distribution, C t is the copula function that captures the joint distribution between two margins, and quantile q = 10% (see Huang and MacDonald, 2013). ∆CT D t is taken as a predictor of exchange rate returns, denoted by T CS.…”

Section: Scapegoat Variablesmentioning

confidence: 99%

“…Our financial data set is obtained from Datastream and Bloomberg, including spot rates, forward rates and risk-free interest rates of weekly (1-week, 2-week, and 3-week), monthly (from 1-month to 11 month consecutively), and annually (1-year) maturities, at-the-money (ATM) option 1-month implied volatilities, 10-delta and 25-delta out-of-the-money (OTM) option 1month risk reversals and butterflies for EUR (EMU), GBP (United Kingdom), AUD (Australia), NZD (New Zealand), CHF (Switzerland), CAD (Canada), and JPY (Japan) 6 . All Option data are used to construct volatility risk premia (see Della Corte, Ramadorai, and Sarno, 2013), skew and kurtosis risk premia (see Huang and MacDonald, 2013), which contain exante information about future exchange rate movements and tail risk premium and are denoted by V RP , SRP , and KRP , respectively. Motivated by the fact that most of the high-yield currencies are commodity currencies, we choose the Raw Industrial Sub-index of the CRB Spot Commodity Index (see also Bakshi and Panayotov, 2013), denoted by CRB.…”

Section: Customer Order Flowsmentioning

confidence: 99%

“…We also adopt CBOE's V IX index, and T-Bill Eurodollar Spread T ED Index as the proxies for global volatility, and liquidity risk, respectively. A currency's crash sensitivity is measured by its lower tail dependence on the whole FX market using copula approach as in Huang and MacDonald (2013). we acquire data on the positions of currency futures traders (both commercial and noncommercial) from the Commitment of Traders (COT) published by the Commodity Futures Trading Commission (CFTC).…”

Section: Customer Order Flowsmentioning

confidence: 99%

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The term structure of exchange rate predictability: Commonality, scapegoat, and disagreement

Cao

Huang²,

Liu

et al. 2019

Journal of International Money and Finance

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In this paper we study the exchange rate predictability across a range of investment horizons by proposing a generalized (term structure) model to capture the risk premium component of exchange rates with a broad set of variables meanwhile handle both parameter and model uncertainty. We demonstrate the existence of time-varying term-structural effect and model disagreement effect of exchange rate predictors as well as the projections of predictive information over the term structure. We further utilize the time-variation in the probability weighting to identify the scapegoat drivers of customer order flows. Our findings suggest that heterogeneous agents learn to forecast exchange rates and switch trading rules over time, resulting in the dynamic country-specific and global exposures of exchange rates to shortrun non-fundamental risk and long-run business cycle risk. Hedging pressure and liquidity are identified to contain predictive information that is common to a range of forecasting horizons. Policy-related predictors are important for short-run forecasts up to 3 months while crash risk indicators matter for long-run forecasts from 9 months to 12 months. We further comprehensively evaluate both statistical and economic significance of the model allowing for a full spectrum of currency investment management, and find that the model generates substantial performance fees of 6.5% per annum. The outperformance is mainly due to (i) the relaxing of restrictions imposed on structural parameters via model generalization, and (ii) the use of factor structure to extract common useful information from noisy data and reduce estimation errors.

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Currency Carry Trades, Position-Unwinding Risk, and Sovereign Credit Premia

Huang

MacDonald

2013

SSRN Journal

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This is the first study that employs option pricing model to measure the position-unwinding risk of currency carry trade portfolios, which covers moment information as the proxy for crash risk. I show that high interest-rate currencies are exposed to higher position-unwinding risk than low interest-rate currencies. I also investigate the sovereign CDS spreads as the proxy for countries' credit conditions and find that high interest rate currencies load up positively on sovereign default risk while low interest rate currencies provide a hedge against it. Sovereign credit premia as the dominant economic fundamental risk, together with position-unwinding likelihood indicator as the market risk (non-neutrality) sentiment, captures over 90% cross-sectional variations of carry trade excess returns. I identify sovereign credit risk as the impulsive country-specific risk that drives market volatility, and also the global contagion channels. Then I propose an alternative carry trade strategy that is immunized from crash risk, and a composite story of sovereign credit premia, global liquidity imbalances and liquidity reversal/spiral for explaining the forward premium puzzle.JEL classification: F31, F37, G12, G13, G15.

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Global Currency Misalignments, Crash Sensitivity, and Downside Insurance Costs

Cited by 3 publications

References 165 publications

Impact of Chinese Yuan Devaluation on the Dependence Structure: The Archimedean Copula Approach

Impact of Chinese Yuan Devaluation on the Dependence Structure: The Archimedean Copula Approach

The term structure of exchange rate predictability: Commonality, scapegoat, and disagreement

Currency Carry Trades, Position-Unwinding Risk, and Sovereign Credit Premia

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