Working Paper: CEPR ID: DP8745
Authors: Mikhail Chernov; Jeremy Graveline; Irina Zviadadze
Abstract: We quantify the sources of risk in currency returns as a first step toward understanding the returns reported for the carry trade. To do this, we develop and estimate an empirical model of exchange rate dynamics using daily data for four currencies relative to the US dollar: the Australian dollar, the British pound, the Swiss franc, and the Japanese yen. The model includes (i) Gaussian shocks with stochastic variance, (ii) jumps up and down in the exchange rate, and (iii) jumps in the variance. We identify these components using data on exchange rates and at-the-money implied variances. We find that the probability of a jump depreciation (appreciation) in the exchange rate is increasing in the domestic (foreign) interest rate. The probability of jumps in variance is increasing in the variance but not related to interest rates. Many of the jumps in exchange rates are associated with macroeconomic and political news, but jumps in variance are not. Overall, jumps account for 25% of total currency risk over horizons of one to three months.
Keywords: Bayesian; MCMC; Carry Trades; Exchange Rates; Implied Volatility; Jumps
JEL Codes: C58; F31; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Domestic Interest Rate (E43) | Probability of Jump Depreciation (C29) |
| Foreign Interest Rate (E43) | Probability of Jump Appreciation (G19) |
| Jump in Variance (C29) | Probability of Further Jumps in Variance (C29) |
| Jump in Exchange Rate (F31) | Jumps Account for Total Currency Risk (F31) |