# Foreign Exchange Risk and the Predictability of Carry Trade Returns

Save this PDF as:

Size: px
Start display at page:

## Transcription

5 2 Theoretical Motivation and Testable Implications 2.1 Market Variance and the ICAPM Since the Intertemporal Capital Asset Pricing Model (ICAPM) of Merton (1973, 1980), a class of asset pricing models has developed which suggests an intertemporal tradeoff between risk and return. These models hold for any risky asset in any market and hence can be applied not only to equities but also to the FX market. For the carry trade, the intertemporal risk-return tradeoff may be expressed as follows: r C,t+1 = µ + κmv t + ε t+1 (1) MV t = ϕ 0 + ϕ 1 AV t + ϕ 2 AC t, (2) where r C,t+1 is the return to the carry trade portfolio from time t to t + 1; MV t is the conditional variance of the returns to the FX market portfolio at time t, termed the FX market variance; AV t is the equally weighted cross-sectional average of the variances of all exchange rate excess returns at time t; AC t is the equally weighted cross-sectional average of the pairwise correlations of all exchange rate excess returns at time t; and ε t+1 is a normally distributed error term at time t+1. These variables will be formally defined in the next section. It is important to note now, however, that the return to the FX market portfolio is simply an equally weighted average of all exchange rate excess returns. The recent literature on crosssectional currency pricing typically uses the FX market portfolio as a standard risk factor (e.g., Lustig, Roussanov and Verdelhan, 2011; Menkhoff, Sarno, Schmeling and Schrimpf, 2012a,b). Equation (1) is a general characterization of the theoretical prediction that there is a positive linear relation between market variance and future excess returns. The coefficient κ on market variance reflects investors risk aversion and hence is assumed to be positive: as risk increases, risk-averse investors require a higher risk premium and the expected return must rise. There is an extensive literature investigating the intertemporal risk-return tradeoff, mainly in equity markets, but the empirical evidence on the sign and statistical significance of the relation is inconclusive. Often the relation between risk and return is found insignificant, 4

6 and sometimes even negative. 3 Equation (2) shows that market variance can be decomposed into average variance and average correlation (with ϕ 1, ϕ 2 > 0), as shown by Pollet and Wilson (2010) for equity returns. This decomposition is an aspect of our analysis that is critical for determining whether the potential predictive ability of market variance is due to movements in average variance or average correlation. In other words, the decomposition is used to clarify what is the source of the predictive information content of market variance. For example, Goyal and Santa-Clara (2003) show that the equally weighted market variance only reflects systematic risk, whereas average variance captures both systematic and idiosyncratic risk. In light of the above, the first testable hypothesis of the empirical analysis is as follows: H1: Market variance is a predictor of future FX excess returns due to one or both of its two components: average variance and average correlation. 2.2 Quantile Regressions and the ICAPM The intertemporal risk-return model of Equations (1) (2) can be applied to the full conditional distribution of returns. The τ-th conditional quantile function for r C,t+1 implied by Equations (1) and (2) is defined as: Q rc,t+1 (τ MV t ) = µ + ( κ + Q N τ ) + ( κ + Q N τ ) MVt = α (τ) + β (τ) MV t, (3) or, given the decomposition of MV into AV and AC, as: Q rc,t+1 (τ AV t, AC t ) = µ + ϕ 0 ( κ + Q N τ ) + ( κ + Q N τ ) ϕ1 AV t + ( κ + Q N t ) ϕ2 AC t = α (τ) + β 1 (τ) AV t + β 2 (τ) AC t, (4) where Q N τ is the τ-th quantile of the normal distribution, which has a large negative value deep 3 See, among others, French, Schwert and Stambaugh (1987), Chan, Karolyi and Stulz (1992), Glosten, Jagannathan and Runkle (1993), Goyal and Santa-Clara (2003), Ghysels, Santa-Clara and Valkanov (2005), and Bali (2008). 5

11 3.5 Average Variance and Average Correlation Our second set of risk measures relies on the Pollet and Wilson (2010) decomposition of MV into the product of two terms, the cross-sectional average variance (AV) and the cross-sectional average correlation (AC), as follows: MV t+1 = AV t+1 AC t+1. (6) The decomposition would be exact if all exchange rates had equal individual variances, but is actually approximate given that exchange rates display unequal variances. Thus, the validity of the decomposition is an empirical matter. Pollet and Wilson (2010) use this decomposition for a large number of stocks and find that the approximation works very well. As we show later, this approximation works remarkably well also for exchange rates. We estimate monthly measures of AV and AC as follows: AV t+1 = 1 N AC t+1 = N V j,t+1, (7) j=1 1 N(N 1) N i=1 N C ij,t+1, (8) where V j,t+1 is the realized monthly variance of the excess return to exchange rate j at month t + 1, which is computed using daily excess returns as follows: j i D t D t V j,t+1 = rj,t+d/d 2 t + 2 r j,t+d/dt r j,t+(d 1)/Dt, (9) d=1 and C ij,t+1 is the realized monthly correlation between the excess returns of exchange rates i and j at month t + 1 computed as: d=2 C ij,t+1 = V ij,t+1 = V ij,t+1 Vi,t+1 Vj,t+1, (10) D t d=1 D t r i,t+d/dt r j,t+d/dt + 2 r i,t+d/dt r j,t+(d 1)/Dt. (11) d=2 10

12 4 Predictive Regressions Our empirical analysis begins with ordinary least squares (OLS) estimation of two predictive regressions for a one-month ahead horizon. The first predictive regression provides a simple way for assessing the intertemporal risk-return tradeoff in FX as follows: r C,t+1 = α + βmv t + ε t+1, (12) where r C,t+1 is the return to the carry trade portfolio from time t to t + 1, and MV t is the market variance from time t 1 to t. This regression will capture whether, on average, the carry trade has low returns following times of high market variance. The second predictive regression assesses the risk-return tradeoff implied by the decomposition of market variance into average variance and average correlation: r C,t+1 = α + β 1 AV t + β 2 AC t + ε t+1, (13) where AV t and AC t are the average variance and average correlation from time t 1 to t. For notational simplicity, we use the same symbol α for the constants in the two regressions. The second regression separates the effect of AV and AC in order to determine which component of MV can predict future carry returns. The simple OLS regressions focus on the effect of the risk measures on the conditional mean of future carry returns. We go further by also estimating two predictive quantile regressions, which are designed to capture the effect of the risk measures on the full distribution of future carry returns. It is possible, for example, that market variance is a poor predictor of the conditional mean return but predicts well one or both tails of the return distribution. In our analysis, we focus on deciles of this distribution. The first predictive quantile regression estimates: Q rc,t+1 (τ MV t ) = α (τ) + β (τ) MV t, (14) 11

14 correlated with the carry and market returns. It is also worth noting that the correlation between AV and AC is 21.3% and 26.8% for the two portfolios. This implies that FX variances and correlations are on average only moderately positively correlated. Moreover, in the bottom row of Figure 1, we show the correlation between AV and AC over time using a five-year rolling window. The figure shows that this correlation fluctuates considerably over time, is often low and can even be negative. Interestingly, during the recent financial crisis only AV increases to unprecedented high levels, whereas AC is around normal values. This further justifies the decomposition of MV into AV and AC as the low correlation of AV and AC indicates that they may capture different types of risk. 5.2 The Decomposition of Market Variance The three FX risk measures of MV, AV and AC are related by the approximate decomposition of Equation (6). We evaluate the empirical validity of the decomposition by presenting regression results in the Internet Appendix. In summary, we find that AV and AC together capture up to 96% of the time variation in MV, and the explanatory power of AV is substantially higher than AC. 5.3 Predictive Regressions We examine the intertemporal risk-return tradeoff for the carry trade by first discussing the results of OLS predictive regressions, reported in Table 2. This also tests the first hypothesis (H1 ) we set out in Section 2. In regressing the one-month ahead carry trade return on MV, the table shows that overall the relation is negative but not statistically significant. This is true for both advanced economies and the global portfolio. Therefore, just by using OLS regressions we cannot find evidence that high market variance is a significant predictor of future carry trade returns. This remains the case when we regress the one-month ahead carry trade return on AV and AC. Although AV and AC are also negatively related to the carry trade return, this result is not statistically significant. Therefore, in the context of OLS predictive regressions, the evidence does not support hypothesis H1 as we find that the FX risk measures are not 13

20 a lower volatility (9.15% vs %) and a higher Sharpe ratio (0.60 vs. 0.52), although its statistical significance is borderline (p-value = 0.10). Finally, consider the 0.1 strategy. In this case, we shut down the carry trade every time the current return is below the bottom decile of the return distribution irrespective of the value of MV. Relative to the carry trade, this strategy delivers a lower return (5.12% vs. 5.34%), a lower volatility (9.09% vs %) and a higher Sharpe ratio (0.56 vs. 0.52) that is now insignificant (p-value = 0.25). 12 When we move from the advanced economies to the global portfolio, the results are slightly different. The 1.0 strategy delivers a much lower return than the carry trade (2.69% vs. 8.10%), a much lower volatility (4.58% vs. 9.12%) and this time a lower Sharpe ratio (0.59 vs. 0.89). Hence for the full distribution of global portfolio returns, the 1.0 strategy yields a worse risk-return ratio than the carry trade. Nonetheless, this finding changes drastically when we also condition on the return quantile. For example, the 0.1 quantile MV strategy provides a higher return (8.58% vs. 8.10%), a lower volatility (7.53% vs. 9.12%) and a much higher Sharpe ratio (1.14 vs. 0.89) with a p-value of Finally, the 0.1 strategy provides a lower return (7.65% vs. 8.10%), a lower volatility (7.66% vs. 9.12%) and a higher Sharpe ratio (1.00 vs. 0.89) with a p-value of To make our case more concrete consider Figure 3, which plots the cumulative returns of the 0.1 quantile MV strategy relative to the standard carry trade. As we can see in the figure, there is virtually no difference in the two strategies in the early part of the sample, when the standard carry trade tends to deliver an increasing cumulative return and the augmented strategy mirrors the standard strategy. However, the difference in the two strategies becomes more pronounced during the recent financial crisis when the augmented strategy performs better. Keep in mind that, in effect, this augmented strategy shuts down the carry trade for about 5% of the time: when the current return is below the bottom 0.1 quantile and MV is higher than its median. Although 95% of the time this augmented strategy is identical to the standard carry trade, it still manages to deliver a higher return, a much lower volatility 12 Note that the 0.1 strategy that conditions on MV and the 0.1 strategy that does not, are similar in the following sense: most of the low returns in the bottom decile tend to be associated with high MV. This is consistent with the theory of Brunnermeier, Nagel and Pedersen (2009) on liquidity spirals and implies that the improvement of the 0.1 strategy over the 0.1 strategy is small but positive. 19

### Average Variance, Average Correlation and Currency Returns

Average Variance, Average Correlation and Currency Returns Gino Cenedese Bank of England Lucio Sarno Cass Business School and CEPR Ilias Tsiakas University of Guelph First version: August 2011 - Revised:

### The Foreign Exchange Market Not As Liquid As You May Think

06.09.2012 Seite 1 / 5 The Foreign Exchange Market Not As Liquid As You May Think September 6 2012 1 23 AM GMT By Loriano Mancini Angelo Ranaldo and Jan Wrampelmeyer The foreign exchange market facilitates

### Online appendix to paper Downside Market Risk of Carry Trades

Online appendix to paper Downside Market Risk of Carry Trades A1. SUB-SAMPLE OF DEVELOPED COUNTRIES I study a sub-sample of developed countries separately for two reasons. First, some of the emerging countries

### Probability Weighting of Rare Events and Currency Returns

Probability Weighting of Rare Events and Currency Returns Fousseni Chabi-Yo and Zhaogang Song March 17, 2013 Currency Returns: Carry Trade Strategy Currency carry trade strategy: borrow in countries with

### The relationship between exchange rates, interest rates. In this lecture we will learn how exchange rates accommodate equilibrium in

The relationship between exchange rates, interest rates In this lecture we will learn how exchange rates accommodate equilibrium in financial markets. For this purpose we examine the relationship between

### Liquidity in the Foreign Exchange Market: Measurement, Commonality, and Risk Premiums

Liquidity in the Foreign Exchange Market: Measurement, Commonality, and Risk Premiums Loriano Mancini Swiss Finance Institute and EPFL Angelo Ranaldo University of St. Gallen Jan Wrampelmeyer University

### Investing in Foreign Currency is like Betting on your Intertemporal Marginal Rate of Substitution.

Investing in Foreign Currency is like Betting on your Intertemporal Marginal Rate of Substitution. Hanno Lustig UCLA and NBER Adrien Verdelhan Boston University December 13, 2005 Abstract Investors earn

### Implied Volatility Skews in the Foreign Exchange Market. Empirical Evidence from JPY and GBP: 1997-2002

Implied Volatility Skews in the Foreign Exchange Market Empirical Evidence from JPY and GBP: 1997-2002 The Leonard N. Stern School of Business Glucksman Institute for Research in Securities Markets Faculty

### The Carry Trade in Industrialized and Emerging Markets

The Carry Trade in Industrialized and Emerging Markets Craig Burnside January 2014 Abstract I revisit the evidence on the profits associated with currency carry trades, explore its relationship to the

### Is the Forward Exchange Rate a Useful Indicator of the Future Exchange Rate?

Is the Forward Exchange Rate a Useful Indicator of the Future Exchange Rate? Emily Polito, Trinity College In the past two decades, there have been many empirical studies both in support of and opposing

### B.3. Robustness: alternative betas estimation

Appendix B. Additional empirical results and robustness tests This Appendix contains additional empirical results and robustness tests. B.1. Sharpe ratios of beta-sorted portfolios Fig. B1 plots the Sharpe

### Yao Zheng University of New Orleans. Eric Osmer University of New Orleans

ABSTRACT The pricing of China Region ETFs - an empirical analysis Yao Zheng University of New Orleans Eric Osmer University of New Orleans Using a sample of exchange-traded funds (ETFs) that focus on investing

### Stock market booms and real economic activity: Is this time different?

International Review of Economics and Finance 9 (2000) 387 415 Stock market booms and real economic activity: Is this time different? Mathias Binswanger* Institute for Economics and the Environment, University

### 5 Carry Trades and Currency Crashes

5 Carry Trades and Currency Crashes Markus K. Brunnermeier, Princeton University, NBER, and CEPR Stefan Nagel, Stanford University and NBER Lasse H. Pedersen, New York University, NBER, and CEPR I. Introduction

### Carry Strategies Don t get Carried away! Krishna Kumar Contact: kriskumar@earthlink.net

Carry Strategies Don t get Carried away! Krishna Kumar Contact: kriskumar@earthlink.net Summary Buying high yielding currency and shorting low-yielding currency has been a profitable strategy and has been

### Carry Trades and Global FX Volatility

Carry Trades and Global FX Volatility Lukas Menkhoff Lucio Sarno Maik Schmeling Andreas Schrimpf February 2009 Department of Economics, Leibniz Universität Hannover, Königsworther Platz 1, 30167 Hannover,

### Downside market risk of carry trades

Downside market risk of carry trades Victoria Dobrynskaya 1 First version: March 2010 This version: March 2013 Abstract Carry trades consistently generate high excess returns with high Sharpe ratios. I

### CAPM, Arbitrage, and Linear Factor Models

CAPM, Arbitrage, and Linear Factor Models CAPM, Arbitrage, Linear Factor Models 1/ 41 Introduction We now assume all investors actually choose mean-variance e cient portfolios. By equating these investors

### Is there Information Content in Insider Trades in the Singapore Exchange?

Is there Information Content in Insider Trades in the Singapore Exchange? Wong Kie Ann a, John M. Sequeira a and Michael McAleer b a Department of Finance and Accounting, National University of Singapore

### The Returns to Currency Speculation in Emerging Markets

The Returns to Currency Speculation in Emerging Markets Craig Burnside, Martin Eichenbaum y, and Sergio Rebelo z February 2007 Abstract The carry trade strategy involves selling forward currencies that

### A Review of Cross Sectional Regression for Financial Data You should already know this material from previous study

A Review of Cross Sectional Regression for Financial Data You should already know this material from previous study But I will offer a review, with a focus on issues which arise in finance 1 TYPES OF FINANCIAL

### Carry Trades and Global FX Volatility

MPRA Munich Personal RePEc Archive Carry Trades and Global FX Volatility Lukas Menkhoff and Lucio Sarno and Maik Schmeling and Andreas Schrimpf Leibniz Universität Hannover, Cass Business School, Center

### BUSM 411: Derivatives and Fixed Income

BUSM 411: Derivatives and Fixed Income 2. Forwards, Options, and Hedging This lecture covers the basic derivatives contracts: forwards (and futures), and call and put options. These basic contracts are

### Session IX: Lecturer: Dr. Jose Olmo. Module: Economics of Financial Markets. MSc. Financial Economics

Session IX: Stock Options: Properties, Mechanics and Valuation Lecturer: Dr. Jose Olmo Module: Economics of Financial Markets MSc. Financial Economics Department of Economics, City University, London Stock

### Forward and Spot Exchange Rates in a Multi-Currency World

Forward and Spot Exchange Rates in a Multi-Currency World Tarek A. Hassan Rui C. Mano Very Preliminary and Incomplete Abstract We decompose the covariance of currency returns with forward premia into a

### Massachusetts Institute of Technology Department of Economics Working Paper Series

Massachusetts Institute of Technology Department of Economics Working Paper Series CARRY TRADE AND SYSTEM RISK: WHY ARE FX OPTIONS SO CHEAP? Ricardo J. Caballero Joseph B. Doyle Working Paper 12-28 December

### Global Currency Hedging

Global Currency Hedging John Y. Campbell, Karine Serfaty-de Medeiros, and Luis M. Viceira 1 First draft: June 2006 This draft: October 2008 1 Campbell: Department of Economics, Littauer Center 213, Harvard

### SAMPLE MID-TERM QUESTIONS

SAMPLE MID-TERM QUESTIONS William L. Silber HOW TO PREPARE FOR THE MID- TERM: 1. Study in a group 2. Review the concept questions in the Before and After book 3. When you review the questions listed below,

### Carry Trades and Currency Crashes

Carry Trades and Currency Crashes Markus K. Brunnermeier, Stefan Nagel, Lasse Pedersen Princeton, Stanford, NYU AEA Meetings, January 2008 BNP (2008) Carry Trades & Currency Crashes AEA, Jan 2008 1 / 23

### The Cross-Section of Currency Order Flow Portfolios

The Cross-Section of Currency Order Flow Portfolios Lukas Menkhoff Lucio Sarno Maik Schmeling Andreas Schrimpf This version: May 18, 2012 We would like to thank Alessandro Beber, Geir Bjønnes, Jacob Gyntelberg,

### Rethinking Fixed Income

Rethinking Fixed Income Challenging Conventional Wisdom May 2013 Risk. Reinsurance. Human Resources. Rethinking Fixed Income: Challenging Conventional Wisdom With US Treasury interest rates at, or near,

### Traditionally, venturing outside the United States has involved two investments:

WisdomTree ETFs INTERNATIONAL HEDGED EQUITY FUND HDWM Approximately 50% of the world s equity opportunity set is outside of the United States, 1 and the majority of that is in developed international stocks,

### VANDERBILT AVENUE ASSET MANAGEMENT

SUMMARY CURRENCY-HEDGED INTERNATIONAL FIXED INCOME INVESTMENT In recent years, the management of risk in internationally diversified bond portfolios held by U.S. investors has been guided by the following

### THE PRICING OF RISK IN THE CARRY TRADE

THE PRICING OF RISK IN THE CARRY TRADE by Wenna Lu A Thesis Submitted in Fulfilment of the Requirements for the Degree of Doctor of Philosophy of Cardiff University Economics Section of Cardiff Business

### Portfolio Performance Measures

Portfolio Performance Measures Objective: Evaluation of active portfolio management. A performance measure is useful, for example, in ranking the performance of mutual funds. Active portfolio managers

### Chap 3 CAPM, Arbitrage, and Linear Factor Models

Chap 3 CAPM, Arbitrage, and Linear Factor Models 1 Asset Pricing Model a logical extension of portfolio selection theory is to consider the equilibrium asset pricing consequences of investors individually

### Online Appendix: Conditional Risk Premia in Currency Markets and. Other Asset Classes. Martin Lettau, Matteo Maggiori, Michael Weber.

Online Appendix: Conditional Risk Premia in Currency Markets and Other Asset Classes Martin Lettau, Matteo Maggiori, Michael Weber. Not for Publication We include in this appendix a number of details and

### Optimization of technical trading strategies and the profitability in security markets

Economics Letters 59 (1998) 249 254 Optimization of technical trading strategies and the profitability in security markets Ramazan Gençay 1, * University of Windsor, Department of Economics, 401 Sunset,

### Global Currency Hedging

Global Currency Hedging John Y. Campbell Harvard University Arrowstreet Capital, L.P. May 16, 2010 Global Currency Hedging Joint work with Karine Serfaty-de Medeiros of OC&C Strategy Consultants and Luis

### Trading Probability and Turnover as measures of Liquidity Risk: Evidence from the U.K. Stock Market. Ian McManus. Peter Smith.

Trading Probability and Turnover as measures of Liquidity Risk: Evidence from the U.K. Stock Market. Ian McManus (Corresponding author). School of Management, University of Southampton, Highfield, Southampton,

### INFLATION, INTEREST RATE, AND EXCHANGE RATE: WHAT IS THE RELATIONSHIP?

107 INFLATION, INTEREST RATE, AND EXCHANGE RATE: WHAT IS THE RELATIONSHIP? Maurice K. Shalishali, Columbus State University Johnny C. Ho, Columbus State University ABSTRACT A test of IFE (International

### BANK FOR INTERNATIONAL SETTLEMENTS P.O. BOX, 4002 BASLE, SWITZERLAND

BANK FOR INTERNATIONAL SETTLEMENTS P.O. BOX, 4002 BASLE, SWITZERLAND PRESS RELEASE CENTRAL BANK SURVEY OF FOREIGN EXCHANGE AND DERIVATIVES MARKET ACTIVITY IN APRIL 1998: PRELIMINARY GLOBAL DATA The BIS

### Hedging Illiquid FX Options: An Empirical Analysis of Alternative Hedging Strategies

Hedging Illiquid FX Options: An Empirical Analysis of Alternative Hedging Strategies Drazen Pesjak Supervised by A.A. Tsvetkov 1, D. Posthuma 2 and S.A. Borovkova 3 MSc. Thesis Finance HONOURS TRACK Quantitative

### Futures Price d,f \$ 0.65 = (1.05) (1.04)

24 e. Currency Futures In a currency futures contract, you enter into a contract to buy a foreign currency at a price fixed today. To see how spot and futures currency prices are related, note that holding

### Currency Momentum Strategies

Currency Momentum Strategies Lukas Menkhoff Lucio Sarno Maik Schmeling Andreas Schrimpf Abstract We provide a broad empirical investigation of momentum strategies in foreign exchange markets. We find a

### Vanguard research July 2014

The Understanding buck stops here: the hedge return : Vanguard The impact money of currency market hedging funds in foreign bonds Vanguard research July 214 Charles Thomas, CFA; Paul M. Bosse, CFA Hedging

### Carry Trades and Currency Crashes: A Comment

Carry Trades and Currency Crashes: A Comment Craig Burnside y July 2008 Abstract The failure of uncovered interest parity and the pro tability of the carry trade in currencies are intimately related, and

### Benchmarking Low-Volatility Strategies

Benchmarking Low-Volatility Strategies David Blitz* Head Quantitative Equity Research Robeco Asset Management Pim van Vliet, PhD** Portfolio Manager Quantitative Equity Robeco Asset Management forthcoming

### Target Strategy: a practical application to ETFs and ETCs

Target Strategy: a practical application to ETFs and ETCs Abstract During the last 20 years, many asset/fund managers proposed different absolute return strategies to gain a positive return in any financial

### Do Direct Stock Market Investments Outperform Mutual Funds? A Study of Finnish Retail Investors and Mutual Funds 1

LTA 2/03 P. 197 212 P. JOAKIM WESTERHOLM and MIKAEL KUUSKOSKI Do Direct Stock Market Investments Outperform Mutual Funds? A Study of Finnish Retail Investors and Mutual Funds 1 ABSTRACT Earlier studies

### Introduction, Forwards and Futures

Introduction, Forwards and Futures Liuren Wu Zicklin School of Business, Baruch College Fall, 2007 (Hull chapters: 1,2,3,5) Liuren Wu Introduction, Forwards & Futures Option Pricing, Fall, 2007 1 / 35

### Chapter Review and Self-Test Problems

CHAPTER 22 International Corporate Finance 771 3. The fundamental relationships between international financial variables: a. Absolute and relative purchasing power parity, PPP b. Interest rate parity,

### The Determinants and the Value of Cash Holdings: Evidence. from French firms

The Determinants and the Value of Cash Holdings: Evidence from French firms Khaoula SADDOUR Cahier de recherche n 2006-6 Abstract: This paper investigates the determinants of the cash holdings of French

### Discussion of The Returns to Currency Speculation

Discussion of The Returns to Currency Speculation John H. Cochrane January 5, 2007 UIP Uk interest rate = 5%, US interest rate = 2%. Invest in UK? 1. Naive: Yes, Make 3% more 2. Traditional: No, Pound

### The Long-Run Performance of the New Zealand Stock Markets: 1899-2012

The Long-Run Performance of the New Zealand Stock Markets: 1899-2012 Bart Frijns * & Alireza Tourani-Rad Auckland Centre for Financial Research (ACFR) Department of Finance, Faculty of Business and Law,

### FX strategies in periods of distress 1

Jacob Gyntelberg Andreas Schrimpf jacob.gyntelberg@bis.org andreas.schrimpf@bis.org FX strategies in periods of distress 1 This article presents an overview of widely practised short-term multicurrency

### International fixed income: The investment case FOR EXISTING VANGUARD ADVICE CLIENT USE ONLY. NOT FOR DISTRIBUTION

International fixed income: The investment case Why international fixed income? International bonds currently make up the largest segment of the securities market Ever-increasing globalization and access

### CHAPTER 23: FUTURES, SWAPS, AND RISK MANAGEMENT

CHAPTER 23: FUTURES, SWAPS, AND RISK MANAGEMENT PROBLEM SETS 1. In formulating a hedge position, a stock s beta and a bond s duration are used similarly to determine the expected percentage gain or loss

### AN AUGMENTED TRADE-WEIGHTED INDEX OF THE AUSTRALIAN DOLLAR 1

AN AUGMENTED TRADE-WEIGHTED INDEX OF THE AUSTRALIAN DOLLAR 1 Introduction Trade-weighted exchange rate indices provide a guide to a country s exchange rate against the currencies of its trading partners,

### Practice questions: Set #1

International Financial Management Professor Michel A. Robe Practice questions: Set #1 What should you do with this set? To help students prepare for the exam and the case, several problem sets with solutions

### 8. Eurodollars: Parallel Settlement

8. Eurodollars: Parallel Settlement Eurodollars are dollar balances held by banks or bank branches outside the country, which banks hold no reserves at the Fed and consequently have no direct access to

### Crisis Alpha and Risk in Alternative Investment Strategies

Crisis Alpha and Risk in Alternative Investment Strategies KATHRYN M. KAMINSKI, PHD, RPM RISK & PORTFOLIO MANAGEMENT AB ALEXANDER MENDE, PHD, RPM RISK & PORTFOLIO MANAGEMENT AB INTRODUCTION The investment

### CHAPTER 22: FUTURES MARKETS

CHAPTER 22: FUTURES MARKETS 1. a. The closing price for the spot index was 1329.78. The dollar value of stocks is thus \$250 1329.78 = \$332,445. The closing futures price for the March contract was 1364.00,

### Foreign Exchange Trading Strategies and Rare Events

Foreign Exchange Trading Strategies and Rare Events Jason Cen and Ian W. Marsh Cambridge Judge Business School and Cass Business School February 15, 2016 Abstract We study the properties of carry trade

### How Hedging Can Substantially Reduce Foreign Stock Currency Risk

Possible losses from changes in currency exchange rates are a risk of investing unhedged in foreign stocks. While a stock may perform well on the London Stock Exchange, if the British pound declines against

### Introduction to Exchange Rates and the Foreign Exchange Market

Introduction to Exchange Rates and the Foreign Exchange Market 2 1. Exchange Rate Essentials 2. Exchange Rates in Practice 3. The Market for Foreign Exchange 4. Arbitrage and Spot Exchange Rates 5. Arbitrage

### 2. Discuss the implications of the interest rate parity for the exchange rate determination.

CHAPTER 6 INTERNATIONAL PARITY RELATIONSHIPS AND FORECASTING FOREIGN EXCHANGE RATES SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS QUESTIONS 1. Give a full definition of arbitrage.

### 96 97 98 99 00 01 02 03 04 05 06 07 08* FDI Portfolio Investment Other investment

Chartbook Contact: Sebastian Becker +49 69 91-3664 Global Risk Analysis The unwinding of Yen carry trades Some empirical evidence 3 2 1-1 -2-3 -4 October 31, 28 Many years before the sub-prime crisis hit

### The Equity Premium in India

The Equity Premium in India Rajnish Mehra University of California, Santa Barbara and National Bureau of Economic Research January 06 Prepared for the Oxford Companion to Economics in India edited by Kaushik

### Does an Optimal Static Policy Foreign Currency Hedge Ratio Exist?

May 2015 Does an Optimal Static Policy Foreign Currency Hedge Ratio Exist? FQ Perspective DORI LEVANONI Partner, Investments ANNA SUPERA-KUC CFA Director Investing in foreign assets comes with the additional

### Business 4079. Assignment 2 Suggested Answers. 1. Describe how the following transactions are recorded in the balance of payments.

Business 079 Assignment 2 Suggested Answers. Describe how the following transactions are recorded in the balance of payments. (a) A Hong Kong resident, who owns a house valued at C\$500,000, migrates to

### Life Cycle Asset Allocation A Suitable Approach for Defined Contribution Pension Plans

Life Cycle Asset Allocation A Suitable Approach for Defined Contribution Pension Plans Challenges for defined contribution plans While Eastern Europe is a prominent example of the importance of defined

### What Do Stock Markets Tell Us About Exchange Rates?

What Do Stock Markets Tell Us About Exchange Rates? Gino Cenedese Richard Payne Lucio Sarno Giorgio Valente This draft: December 18, 2013 Abstract The Uncovered Equity Parity (UEP) condition states that

### DOES IT PAY TO HAVE FAT TAILS? EXAMINING KURTOSIS AND THE CROSS-SECTION OF STOCK RETURNS

DOES IT PAY TO HAVE FAT TAILS? EXAMINING KURTOSIS AND THE CROSS-SECTION OF STOCK RETURNS By Benjamin M. Blau 1, Abdullah Masud 2, and Ryan J. Whitby 3 Abstract: Xiong and Idzorek (2011) show that extremely

### Handout 2: The Foreign Exchange Market 1

University of Bern Prof. H. Dellas International Finance Winter semester 01/02 Handout 2: The Foreign Exchange Market 1 1 Financial Instruments in the FOREX markets Forward contracts Large, non standardized

### EXTERNAL DEBT AND LIABILITIES OF INDUSTRIAL COUNTRIES. Mark Rider. Research Discussion Paper 9405. November 1994. Economic Research Department

EXTERNAL DEBT AND LIABILITIES OF INDUSTRIAL COUNTRIES Mark Rider Research Discussion Paper 9405 November 1994 Economic Research Department Reserve Bank of Australia I would like to thank Sally Banguis

### Effective downside risk management

Effective downside risk management Aymeric Forest, Fund Manager, Multi-Asset Investments November 2012 Since 2008, the desire to avoid significant portfolio losses has, more than ever, been at the front

### Foreign Exchange (FX) market - Introduction

Foreign Exchange (FX) market - Introduction Ruichang LU ( 卢瑞昌 ) Department of Finance Guanghua School of Management Peking University The Foreign Exchange (forex) Market The forex market is the physical

### Why own bonds when yields are low?

Why own bonds when yields are low? Vanguard research November 213 Executive summary. Given the backdrop of low yields in government bond markets across much of the developed world, many investors may be

### Chapter 20. Short-Term Financing. Lecture Outline. Sources of Short-Term Financing. Internal Financing by MNCs

Chapter 20 Short-Term Financing Lecture Outline Sources of Short-Term Financing Internal Financing by MNCs Why MNCs Consider Foreign Financing Foreign Financing to Offset Foreign Currency Inflows Foreign

### EVALUATING THE PERFORMANCE CHARACTERISTICS OF THE CBOE S&P 500 PUTWRITE INDEX

DECEMBER 2008 Independent advice for the institutional investor EVALUATING THE PERFORMANCE CHARACTERISTICS OF THE CBOE S&P 500 PUTWRITE INDEX EXECUTIVE SUMMARY The CBOE S&P 500 PutWrite Index (ticker symbol

### Chapter 5 Financial Forwards and Futures

Chapter 5 Financial Forwards and Futures Question 5.1. Four different ways to sell a share of stock that has a price S(0) at time 0. Question 5.2. Description Get Paid at Lose Ownership of Receive Payment

### Staying alive: Bond strategies for a normalising world

Staying alive: Bond strategies for a normalising world Dr Peter Westaway Chief Economist, Europe Vanguard Asset Management November 2013 This document is directed at investment professionals and should

### Study on the Volatility Smile of EUR/USD Currency Options and Trading Strategies

Prof. Joseph Fung, FDS Study on the Volatility Smile of EUR/USD Currency Options and Trading Strategies BY CHEN Duyi 11050098 Finance Concentration LI Ronggang 11050527 Finance Concentration An Honors

### Introduction to Futures Contracts

Introduction to Futures Contracts September 2010 PREPARED BY Eric Przybylinski Research Analyst Gregory J. Leonberger, FSA Director of Research Abstract Futures contracts are widely utilized throughout

### Exchange Risk versus the Value Factor In International Asset Pricing

Exchange Risk versus the Value Factor In International Asset Pricing Hong Wu Division of Economics and Finance College of Business & Economics West Virginia University Morgantown, WV 26506-6025 hwu3@wvu.edu

### CHAPTER 22: FUTURES MARKETS

CHAPTER 22: FUTURES MARKETS PROBLEM SETS 1. There is little hedging or speculative demand for cement futures, since cement prices are fairly stable and predictable. The trading activity necessary to support

### Carry Trades and Global Foreign Exchange Volatility

Carry Trades and Global Foreign Exchange Volatility Lukas Menkhoff Lucio Sarno Maik Schmeling Andreas Schrimpf February 2010 The authors would like to thank Alessandro Beber, Craig Burnside, Marcel Fratzscher,

### Risk Management Series

AAA AAA AAA AAA AAA AAA AAA AAA AAA AAA January 1996 Managing Market Exposure Robert Litterman Kurt Winkelmann Acknowledgements The authors are grateful to Mike Asay, Alex Bergier, Jean- Paul Calamaro,

Chapter 9 The Case for International Diversification Introduction In this chapter we cover: The advantages and disadvantages of international investing. Present the traditional case for international diversification.

### BIS Working Papers No 366. Currency Momentum Strategies. Monetary and Economic Department

BIS Working Papers No 366 Currency Momentum Strategies by Lukas Menkhoff, Lucio Sarno, Maik Schmeling and Andreas Schrimpf Monetary and Economic Department December 2011 JEL classification: F31, G12, G15.

### Evidence: Typically country by country time series regressions, following Fama s original

FX We regoingtoreviewthecurrentstateoffxwork. Inmyopinionit sagoodbit behind the stock and bond work above, which means low-hanging fruit for you to apply the same ideas. (Note Lustig et. al. as a low

### GOVERNMENT PENSION FUND GLOBAL HISTORICAL PERFORMANCE AND RISK REVIEW

GOVERNMENT PENSION FUND GLOBAL HISTORICAL PERFORMANCE AND RISK REVIEW 10 March 2014 Content Scope... 3 Executive summary... 3 1 Return and risk measures... 4 1.1 The GPFG and asset class returns... 4 1.2

### Tilted Portfolios, Hedge Funds, and Portable Alpha

MAY 2006 Tilted Portfolios, Hedge Funds, and Portable Alpha EUGENE F. FAMA AND KENNETH R. FRENCH Many of Dimensional Fund Advisors clients tilt their portfolios toward small and value stocks. Relative

### Investment Insight Diversified Factor Premia Edward Qian PhD, CFA, Bryan Belton, CFA, and Kun Yang PhD, CFA PanAgora Asset Management August 2013

Investment Insight Diversified Factor Premia Edward Qian PhD, CFA, Bryan Belton, CFA, and Kun Yang PhD, CFA PanAgora Asset Management August 2013 Modern Portfolio Theory suggests that an investor s return

### The Abnormal Performance of Bond Returns

The University of Reading THE BUSINESS SCHOOL FOR FINANCIAL MARKETS The Abnormal Performance of Bond Returns Joëlle Miffre ISMA Centre, The University of Reading, Reading, Berks., RG6 6BA, UK Copyright

### Exchange Rates and Foreign Direct Investment

Exchange Rates and Foreign Direct Investment Written for the Princeton Encyclopedia of the World Economy (Princeton University Press) By Linda S. Goldberg 1 Vice President, Federal Reserve Bank of New

03 2014 DISCUSSION NOTE The carry trade in currency markets means that an investor buys a high-yielding currency and finances this by borrowing money in a currency with a low interest rate. The empirical