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Crash Risk in Currency Returns

Published online by Cambridge University Press:  15 January 2018

Mikhail Chernov ,
Jeremy Graveline  and
Irina Zviadadze
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Abstract

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We develop an empirical model of bilateral exchange rates. It includes normal shocks with stochastic variance and jumps in an exchange rate and in its variance. The probability of a jump in an exchange rate corresponding to depreciation (appreciation) of the U.S. dollar is increasing in the domestic (foreign) interest rate. The probability of a jump in variance is increasing in the variance only. Jumps in exchange rates are associated with announcements; jumps in variance are not. On average, jumps account for 25% of currency risk. The dollar carry index retains these features. Options suggest that jump risk is priced.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 53 , Issue 1 , February 2018 , pp. 137 - 170
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2018 

Footnotes

1

We are grateful to an anonymous referee and Hendrik Bessembinder (the editor), as well as many people who gave us advice, including Yacine Ait-Sahalia, David Backus, Magnus Dahlquist, Itamar Drechsler, Bjorn Eraker, Peter Feldhutter, Diego Garcia, Francisco Gomes, Michael Johannes, Igor Makarov, Christopher Neely, Alessandro Palandri, Guillaume Plantin, Nick Roussanov, Lucio Sarno, Paul Schneider, Ivan Shaliastovich, Elvira Sojli, Vladimir Sokolov, Zhaogang Song, Stijn Van Nieuwerburgh, Adrien Verdelhan, Christian Wagner, Amir Yaron, and Stan Zin, as well as participants in seminars at and conferences sponsored by the American Economic Association (AEA), BI Oslo, University of Chicago, Ecole des Hautes Etudes Commerciales du Nord (EDHEC), the Federal Reserve, Goldman Sachs, Imperial College, London Business School (LBS), London School of Economics (LSE), Montreal Structured Finance and Derivatives Institute (IFSID) and Bank of Canada, Moscow Higher School of Economics (HSE), the New York Federal Reserve Bank, New York University, the Society for Economic Dynamics (SED), the Society for Financial Econometrics (SoFiE), Stockholm University, the Swedish House of Finance, Tinbergen Institute, the University of British Columbia, UCLA, the University of North Carolina, and the University of Pennsylvania. Zviadadze gratefully acknowledges support from the AXA Research Fund and Jan Wallander and Tom Hedelius Foundation.

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