The implications of first-order risk aversion for asset market risk premiums

Bekaert, Geert; Hodrick, Robert J.; Marshall, David A.

doi:10.1016/s0304-3932(97)00037-8

Cited by 145 publications

(82 citation statements)

References 41 publications

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“…See also Prachowny (1970), who studies deviations from covered interest rate parity in a model with less than infinitely elastic supply and demand of forward currency. 5 Other relevant papers on this topic include Cumby (1988), Backus, Gregory, and Telmer (1993), Bekaert, Hodrick, and Marshall (1997), Hollifield and Uppal (1997), Mark and Wu (1998), Roll and Yan (2000), Backus, Foresi, and Telmer (2001), Lyons (2001), Gourinchas and Tornell (2004), Lustig and Verdelhan (2007), Albuquerque (2008), Farhi and Gabaix (2008), Wagner (2008), Alvarez, Atkenson, andKehoe (2009), Bansal andShaliastovich (2009), Burnside, results suggest that the failure of the uncovered interest rate parity is due to compensation for risks.…”

Section: Introductionmentioning

confidence: 99%

Speculative capital and currency carry trades

Jylhä

Suominen

2011

Journal of Financial Economics

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In this paper, we study a two-country general equilibrium model with partially segmented financial markets, where hedge funds emerge endogenously. Empirically, we show that the hedge fund investment strategy predicted by our model, which we call the "risk-adjusted carry trade" strategy, explains more than 16% of the overall hedge fund index returns and more than 33% of the fixed income arbitrage sub-index returns. The flow of new money to hedge funds affects market interest rates, exchange rates, and both the hedge funds' contemporaneous and expected future returns as predicted by the model.

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Section: Introductionmentioning

confidence: 99%

Speculative capital and currency carry trades

Jylhä

Suominen

2011

Journal of Financial Economics

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“…It is clear though that predictability is largely overshadowed by risk. 11 This means that for many investors it is simply not worthwhile to actively trade on excess return predictability. Even for those who do actively trade on the excess return predictability, the high risk limits the positions they will take.…”

Section: Introductionmentioning

confidence: 99%

“…Then maximize with respect to the portfolio at t + k. It is shown that V t+k = E t V t+k+1 indeed takes the conjectured form in (11). Starting with the known value function at t + T , V t+T = W 1−γ t+T /(1 − γ), which corresponds to H T = 0, the value function for earlier periods is solved with backward induction, until the value function at time t is computed.…”

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confidence: 99%

Rational Inattention: A Solution to the Forward Discount Puzzle

Bacchetta

Wincoop

2005

SSRN Journal

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The uncovered interest rate parity equation is the cornerstone of most models in international macro. However, this equation does not hold empirically since the forward discount, or interest rate differential, is negatively related to the subsequent change in the exchange rate. This forward discount puzzle implies that excess returns on foreign currency investments are predictable. Motivated by the fact that even today only a tiny fraction of foreign currency holdings are actively managed, we investigate to what extent incomplete information processing can explain this puzzle. Two types of incompleteness are considered: infrequent and partial information processing. We calibrate a two-country general equilibrium model to the data and show that incomplete information processing can fully match the empirical evidence. It can also account for several related empirical phenomena, including that of "delayed overshooting". We also show that incomplete information processing is optimal. Predictability is largely overshadowed by uncertainty about future exchange rates, so that the welfare gain from actively managing foreign exchange positions is small and easily outweighed by a small cost of active portfolio management.

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“…Frankel and Engel (1984); Domowitz and Hakkio (1985) ;Cumby (1988); Mark (1988);Engel (1996); Lustig and Verdelhan (2007). Moreover, it is difficult to explain the rejection of UIP and the forward bias puzzle by recourse to traditional consumption-based asset pricing theories which allow for departures from time-additive preferences (Backus et al, 1993;Bansal et al, 1995;Bekaert, 1996) and from expected utility (Bekaert et al, 1997), or by using popular models of the term structure of interest rates adapted to a multi-currency setting (Bansal, 1997;Backus et al, 2001;Brennan and Xia, 2006). More recently, Verdelhan (2008) offers an explanation to the puzzle based on a model in which investors have preferences with external habits.…”

Section: Related Literature On Uip and Currency Speculationmentioning

confidence: 99%

Risk-Premia, Carry-Trade Dynamics, and Economic Value of Currency Speculation

Wagner

2008

SSRN Journal

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In this paper, we derive the dynamics and assess the economic value of currency speculation by formalizing the concept of a trader inaction range. We show that exchange rate returns comprise a time-varying risk-premium and that uncovered interest parity (UIP) holds in a speculative sense. The often-cited 'forward bias puzzle' originates from the omission of the risk-premium in standard UIP tests. Consistent with its popularity among market professionals, the carry-trade strategy can be rationalized as it systematically collects risk-premia and generates economic value when applied in multi-currency portfolios.

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The implications of first-order risk aversion for asset market risk premiums

Cited by 145 publications

References 41 publications

Speculative capital and currency carry trades

Speculative capital and currency carry trades

Rational Inattention: A Solution to the Forward Discount Puzzle

Risk-Premia, Carry-Trade Dynamics, and Economic Value of Currency Speculation

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