Working Paper

US Equity Tail Risk and Currency Risk Premia

Abstract: We find that a US equity tail risk factor constructed from out-of-the-money S&P 500 put option prices explains the cross-sectional variation of currency excess returns. Currencies highly exposed to this factor offer a low currency risk premium because they appreciate when US tail risk increases. In a reduced-form model, we show that country-specific tail risk factors are priced in the cross section of currency returns only if they contain a global risk component. Motivated by the intuition from the model and by our empirical results, we construct a novel proxy for a global tail risk factor by buying currencies with high US equity tail beta and shorting currencies with low US tail beta. This factor, along with the dollar risk factor, explains a large portion of the cross-sectional variation in the currency carry and momentum portfolios and outperforms other models widely used in the literature.

Keywords: Equity tail risk; Global tail risk; Currency returns; Carry trade; Currency momentum;

JEL Classification: G12; G15; F31;

https://doi.org/10.17016/IFDP.2019.1253

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: International Finance Discussion Papers

Publication Date: 2019-07-08

Number: 1253