General equilibrium pricing of currency and currency options

Du, Du

doi:10.1016/j.jfineco.2013.08.006

Cited by 22 publications

(7 citation statements)

References 55 publications

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“…evidence on the properties of variance and skewness risk in exchange rates (e.g., Carr and Wu, 2007a;Bakshi, Carr, and Wu, 2008;Du, 2013;Della Corte, Ramadorai, and Sarno, 2016;Londono and Zhou, 2016) and also relate our paper to recent work on crash risk in currency markets (see, e.g., Brunnermeier, Nagel, and Pedersen, 2008;Chernov, Graveline, and Zviadadze, 2016;Jurek, 2014;Farhi et al, 2015;Farhi and Gabaix, 2016;Daniel, Hodrick, and Lu, 2016). The link between sovereign risk, higher exchange rate moments, and currency crash risk suggested by our empirical results is also consistent with the literature on asset pricing implications of rare event risk for credit spreads and option prices, recently surveyed by Tsai and Wachter (2015).…”

Section: Motivation and Related Literaturementioning

confidence: 99%

Exchange Rates and Sovereign Risk

et al. 2022

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An increase in a country’s sovereign risk, as measured by credit default swap spreads, is accompanied by a contemporaneous depreciation of its currency and an increase of its volatility. The relation between currency excess returns and sovereign risk is mainly driven by default expectations (rather than distress risk premia) and exposure to global sovereign risk shocks and also emerges in a predictive setting for currency risk premia. We show that a sovereign risk factor is priced in the cross-section of currency returns and that it is not subsumed by the carry factor. This paper was accepted by David Simchi-Levi, finance.

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Section: Motivation and Related Literaturementioning

confidence: 99%

Exchange Rates and Sovereign Risk

et al. 2022

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“…The investors have arbitrage opportunities due to the different levels of jump intensities of money supplies in two countries.λ h =λ f tends to hold during a long time period empirically as in Ref. [12], so E[R s t ] tends to zero according to the above formula. The observation is consistent with the empirical results in Ref.…”

Section: The Modelmentioning

confidence: 99%

“…Their empirical results showed that the innovations to the two risk processes were not very correlated with each other, which was consistent with their model assumption that the diffusive volatility and jump intensity followed their own stochastic process. Instead of studying equilibrium stock options pricing in Santa-Clara and Yan [21], Du [12] studied equilibrium currency options pricing under recursive utility. In his consumption-based model, the consumptions in domestic and foreign countries were highly but imperfectly shared disaster with time-varying jump intensities.…”

Section: Introductionmentioning

confidence: 99%

Equilibrium Valuation of Currency Options Under a Discontinuous Model With Co-Jumps

Xing

Niu

2020

Prob. Eng. Inf. Sci.

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In this paper, we study the equilibrium valuation for currency options in a setting of the two-country Lucas-type economy. Different from the continuous model in Bakshi and Chen [1], we propose a discontinuous model with jump processes. Empirical findings reveal that the jump components in each country's money supply can be decomposed into the simultaneous co-jump component and the country-specific jump component. Each of the jump components is modeled with a Poisson process whose jump intensity follows a mean reversion stochastic process. By solving a partial integro-differential equation (PIDE), we get a closed-form solution to the PIDE for a European call currency option. The numerical results show that the derived option pricing formula is efficient for practical use. Importantly, we find that the co-jump has a significant impact on option price and implied volatility.

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“…Following the work of Du (2013), we use risk reversal to represent intermediary risk aversion. Risk reversal is regarded as a kind of insurance.…”

Section: Risk Aversion Channelmentioning

confidence: 99%

“…Consequently, intermediaries would require higher carry trade returns as compensation for bearing risk. To test our expectation, we first follow the work of Du (2013) in capturing risk aversion through so‐called risk reversal, which is the difference between the implied volatility of an out‐of‐the‐money call option and the implied volatility of an equally out‐of‐the‐money put. It measures the cost of buying protection on a currency position to limit possible gains and losses, since the price of risk reversal is positive (negative) if the risk‐neutral distribution of the exchange rate is positively (negatively) skewed.…”

Section: Introductionmentioning

confidence: 99%

Intermediary asset pricing in currency carry trade returns

Yin

Nie

2021

Journal of Futures Markets

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This paper examines how intermediary capital risk (ICR) is priced in currency carry trades. In both in-sample and out-of-sample settings, ICR holds strong explanatory power for time-series currency returns. ICR is also a key driver of currency returns with a positive risk price in the cross section, suggesting that financial intermediaries are marginal investors in currency markets. We find an asymmetric effect of ICR, with currencies being more sensitive to negative ICR. Moreover, heterogeneity of ICR is significant only for emerging economies, and the economic channel for the relationship stems from the influence of ICR on intermediary risk aversion. K E Y W O R D Scarry trade excess returns, emerging economies, intermediary capital risk, risk aversion | INTRODUCTIONThe apparent failure of the theory of uncovered interest parity (UIP) has long attracted great attention in international finance, and the currency carry trade strategy has proliferated in practice for at least 45 years (Ready et al., 2017;Suh, 2019). Theoretical advances have been made in understanding the role of peso effects in carry trade payoffs (Burnside et al., 2011;Farhi & Gabaix, 2016). Empirically, a plethora of studies has spared no effort in identifying risk factors that drive premia in a cross-sectional context. 1 Unlike these studies, this paper aims to provide novel evidence that intermediary capital risk (ICR) is a potential source of risk in the currency market.Admittedly, a close connection has always existed between financial institutions and currency markets. Financial institutions are major players in foreign exchange (FX) markets, and retail investors account for a very small relative portion of total forex volume, which is considerably less than their shares in stock and bond markets. 2 Major commercial and investment banks are the largest currency market traders and collectively provide considerable liquidity to currency markets by providing bid-ask prices to clients as well as speculating for their banks' proprietary trading accounts. When releasing macro forecasts, these institutions adjust their strategies, which could indirectly lead to revisions in investor expectations regarding the price paths of currencies (

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General equilibrium pricing of currency and currency options

Cited by 22 publications

References 55 publications

Exchange Rates and Sovereign Risk

Exchange Rates and Sovereign Risk

Equilibrium Valuation of Currency Options Under a Discontinuous Model With Co-Jumps

Intermediary asset pricing in currency carry trade returns

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