Wagner, Christian (2009): Risk-Premia, Carry-Trade Dynamics, and Economic Value of Currency Speculation.
Download (1MB) | Preview
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.
|Item Type:||MPRA Paper|
|Original Title:||Risk-Premia, Carry-Trade Dynamics, and Economic Value of Currency Speculation|
|Keywords:||Exchange rates; Uncovered interest parity; Risk-premia; Carry-trade; Economic value|
|Subjects:||F - International Economics > F3 - International Finance > F31 - Foreign Exchange|
|Depositing User:||Christian Wagner|
|Date Deposited:||07. Mar 2010 00:33|
|Last Modified:||13. Feb 2013 10:00|
Backus, D. K., Foresi, S., Telmer, C. I., 2001, "Affine Term Structure Models and the Forward Premium Anomaly," Journal of Finance, 56, 279-304.
Backus, D. K., Gregory, A. W., Telmer, C. I., 1993, "Accounting for Forward Rates in Markets for Foreign Currency," Journal of Finance, 48, 1887-1908.
Bansal, R., 1997, "An Exploration of the Forward Premium Puzzle in Currency Markets," Review of Financial Studies, 10, 369-403.
Bansal, R., Gallant, A. R., Hussey, R., Tauchen, G., 1995, "Non-Parametric Estimation of Structural Models for High Frequency Currency Market Data," Journal of Econometrics, 66, 251-287.
Barnhart, S. W., McNown, R., Wallace, M. S., 1999, "Non-Informative Tests of the Unbiased Forward Exchange Rate," Journal of Financial and Quantitative Analysis, 34, 265-291.
Bekaert, G., 1996, "The Time-Variation of Risk and Return in Foreign Exchange Markets: A General Equilibrium Perspective," Review of Financial Studies, 9, 427-470.
Bekaert, G., Hodrick, R. J., 1993, "On Biases in the Measurement of Foreign Exchange Risk Premiums," Journal of International Money and Finance, 12, 115-138.
Bekaert, G., Hodrick, R. J., 2001, "Expectations Hypotheses Tests," Journal of Finance, 56, 1357-1394.
Bekaert, G., Hodrick, R. J., 2009, International Financial Management, Prentice-Hall.
Bekaert, G., Hodrick, R. J., Marshall, D., 1997, "The Implications of First-Order Risk Aversion for Asset Market Risk Premiums," Journal of Monetary Economics, 40, 3-39.
Bilson, J. F. O., 1981, "The Speculative Efficiency Hypothesis," Journal of Business, 54, 435-451.
Bjonnes, G. H., Rime, D., 2005, "Dealer Behavior and Trading Systems in Foreign Exchange Markets," Journal of Financial Economics, 75, 571-605.
Boudoukh, J., Richardson, M., Whitelaw, R., 2006, "The Information in Long-Maturity Forward Rates: Implications for Exchange Rates and the Forward Premium Anomaly," NBER Working Paper 11840.
Brennan, M., Xia, Y., 2006, "International Capital Markets and Foreign Exchange Risk," Review of Financial Studies, 19, 753-795.
Brenner, R. J., Kroner, K. F., 1995, "Arbitrage, Cointegration, and Testing the Unbiasedness Hypothesis in Financial Markets," Journal of Financial and Quantitative Analysis, 30, 23-42.
Brunnermeier, M., Nagel, S., Pedersen, L., 2008, "Carry Trades and Currency Crashes," NBER Macroeconomics Annual, 23.
Burnside, C., Eichenbaum, M., Kleshehelski, I., Rebelo, S., 2006, "The returns to currency speculation," NBER Working Paper No. W12489, Cambridge, MA.
Burnside, C., Eichenbaum, M., Rebelo, S., 2008, "Carry Trade: The Gains of Diversification," Journal of the European Economic Association, 6, 581-588.
Clarida, R. H., Sarno, L., Taylor, M. P., Valente, G., 2003, "The Out-of-Sample Success of Term Structure Models as Exchange Rate Predictors: A Step Beyond," Journal of International Economics, 60, 61-83.
Clarida, R. H., Taylor, M. P., 1997, "The Term Structure of Forward Exchange Premiums and the Forecastability of Spot Exchange Rates: Correcting the Errors," Review of Economics and Statistics, 79, 353-361.
Cumby, R. E., 1988, "Is It Risk? Explaining Deviations from Uncovered Interest Parity," Journal of Monetary Economics, 22, 279-299.
Della Corte, P., Sarno, L., Tsiakas, I., 2008, "An Economic Evaluation of Empirical Exchange Rate Models," Review of Financial Studies, forthcoming.
Deutsche Bank, 2004, "Forward Rate Bias: What it is," Global Markets Research.
Dominguez, K., Panthaki, F., 2006, "What Defines `News' in Foreign Exchange Markets?," Journal of International Money and Finance, 25, 168-198.
Domowitz, I., Hakkio, C., 1985, "Conditional Variance and the Risk Premium in the Foreign Exchange Market," Journal of International Economics, 19, 47-66.
Engel, C., 1996, "The Forward Discount Anomaly and the Risk Premium: A Survey of Recent Evidence," Journal of Empirical Finance, 3, 132-192.
Engel, C., Hamilton, J., 1990, "Long swings in the dollar: are they in the data and do markets know it?," American Economic Review, 80, 689-713.
Evans, M. D. D., Lyons, R. K., 2002, "Order Flow and Exchange Rate Dynamics," Journal of Political Economy, 110, 170-180.
Evans, M. D. D., Lyons, R. K., 2004, "A new Micro Model of Exchange Rate Dynamics," NBER Working Paper 10379.
Evans, M. D. D., Lyons, R. K., 2006, "Understanding Order Flow," International Journal of Finance and Economics, 11, 3-23.
Fama, E. F., 1984, "Forward and Spot Exchange Rates," Journal of Monetary Economics, 14, 319-338.
Farhi, E., Gabaix, X., 2008, "Rare Disasters and Exchange Rates," Harvard University, Working Paper.
Frankel, J. A., Engel, C., 1984, "Do Asset Demand Functions Optimize Over the Mean and Variance of Real Returns? A Six Currency Test," Journal of International Economics, 17, 309-323.
Froot, K. A., Thaler, R. H., 1990, "Anomalies: Foreign Exchange," The Journal of Economic Perspectives, 4, 179-192.
Galati, G., Heath, A., McGuire, P., 2007, "Evidence of carry trade activity," BIS Quarterly Review, pp. 27-41.
Galati, G., Melvin, M., 2004, "Why has FX Trading Surged? Explaining the 2004 Triennial Survey," BIS Quarterly Review, pp. 67-74.
Greene, W. H., 2003, Econometric Analysis, Prentice Hall, New Jersey, 5 edn.
Hansen, L. P., Hodrick, R. J., 1980, "Forward Exchange Rates as Optimal Predictors of Future Spot Rates: An Econometric Analysis," Journal of Political Economy, 88, 829-853.
Hochradl, M., Wagner, C., 2008, "Trading the Forward Bias: Are there Limits to Speculation?," European Finance Association 2006 Zurich Meetings Paper.
Hodrick, R., 1992, "An Interpretation of Foreign Exchange Market Efficiency Test," Northwestern University, mimeo.
Hodrick, R. J., 1987, The Empirical Evidence on the Efficiency of Forward and Futures Foreign Exchange Markets, Harwood.
Ito, T., Lyons, R. K., Melvin, M. T., 1998, "Is There Private Information in the FX Market? The Tokyo Experiment," Journal of Finance, pp. 1111-1130.
Jurek, J. W., 2008, "Crash-neutral Currency Carry Trades," Princeton University, Working Paper.
Lewis, K. K., 1995, "Puzzles in International Financial Markets," In: G. M. Grossman, \smallK. Rogoff (Eds.), , vol. 3, . pp. 1913-1971, Elsevier North Holland, Amsterdam.
Lustig, H., Verdelhan, A., 2007, "The Cross-Section of Currency Risk Premia and US Consumption Growth Risk," American Economic Review, 97, 89-117.
Lyons, R. K., 1995, "Tests of Microstructural Hypotheses in Foreign Exchange Markets," Journal of Financial Economics, 39, 321-351.
Lyons, R. K., 2001, The Microstructure Approach to Exchange Rates, MIT Press.
Lyons, R. K., 2002, "Foreign Exchange: Macro Puzzles, Micro Tools," Economic Review, Federal Reserve Bank of San Francisco, pp. 51-69.
Mark, N. C., 1988, "Time Varying Betas and Risk Premia in the Pricing of Forward Foreign Exchange Contracts," Journal of Financial Economics, 22, 335-354.
Newey, W., West, K., 1987, "A Simple Positive Semi-Definite, Heteroscedasticity and Autorcorrelation Consitent Covariance Matrix," Econometrica, 55, 703-708.
Rime, D., 2001, "US Exchange Rates and Currency Flows," Mimeo Stockholm Institute for Financial Research.
Rime, D., Sarno, L., Sojli, E., 2008, "Exchange Rate Forecasting, Order Flow and Macroeconomic Information," Norges Bank Working Paper.
Sarno, L., 2005, "Towards a Solution to the Puzzles in Exchange Rate Economics: Where Do We Stand?," Canadian Journal of Economics, 38, 673-708.
Sarno, L., Valente, G., Leon, H., 2006, "Nonlinearity in Deviations from Uncovered Interest Parity: An Explanation of the Forward Bias Puzzle," Review of Finance, 10, 443-482.
Taylor, M. P., 1995, "The Economics of Exchange Rates," Journal of Economic Literature, 33, 13-47.
Taylor, M. P., Sager, M., 2008, "Commercially Available Order Flow Data and Exchange Rate Movements: Caveat Emptor," Journal of Money, Credit and Banking, 40, 583-625.
Verdelhan, A., 2008, "A Habit-Based Explanation of the Exchange Rate Risk Premium," Journal of Finance, forthcoming.
Villanueva, O. M., 2007, "Forecasting Currency Excess Returns: Can the Forward Bias be Exploited?," Journal of Financial and Quantitative Analysis, 42, 963-990.
Zivot, E., 2000, "Cointegration and Forward and Spot Exchange Rate Regressions," Journal of International Money and Finance, 19, 785-812.