Variance risk premium is arguably one of the most important and robust risk premia documented in the academic finance. The first chapter of this thesis deals with variance risk on the FX market: therein, I recover risk-neutralized covariance matrices of currency returns and combine them with ex post realized covariance matrices to determine the sign of the premium, associate portfolios ranked from highest to lowest premium values with popular currency factors, study the determinants of the FX variance risk and its explore asset pricing properties. I find evidence for an overall negative FX variance risk premium, but also document existence of strategies with a significantly positive one. Among portfolios with the most negative premium estimates, the US dollar index and Carry trade familiarly emerge. I report that portfolios of negative spot return momentum and high recently realized variance exhibit more negative FX variance risk premium. As far as the asset pricing properties are concerned, the Carry trade variance risk dominates the US dollar variance risk as a priced factor, contributing to resolution of the differential pricing of "good and bad'' carry portfolios. The second chapter studies the dynamics of currency spot and excess returns before policy rate announcements of central banks in developed economies. Therein, Dmitry Borisenko and I show that currencies depreciate before target rate cuts and appreciate before rate hikes. What makes the finding surprising is the fact that the fixed income derivatives market allows to forecast monetary policy decisions accurately enough to make the above drift exploitable by investors: our baseline specification of the trading strategy constructed by going long and short currencies before predicted local rate hikes and cuts earns a significant average return which would be only marginally higher if the forecast quality were perfect. In the third chapter, Nikola Mirkov, Paul Söderl

Maxwell Fry was known internationally for his research into international and domestic financial issues. This book constitutes a tribute to his pioneering work in so many areas, and draws together contributions from a range of academic and policy-making colleagues who were fortunate enough to experience the depth of knowledge and insights which Max

Chapter 11 proposes using foreign exchange rate currency options with different strike prices and maturities to capture both currency risks and expectations, for helping understand currency return dynamics. We show that currency returns, which are notoriously difficult to model empirically, are well-explained by the term structures of forward premia and options-based measures of FX expectations and risk. Although this finding is to be expected, expectations and risk have been largely ignored in empirical exchange-rate modeling. Using daily options data for six major currency pairs, we first show that currency options-implied standard deviation, skewness, and kurtosis consistently improve the explanatory power of quarterly currency returns than a standardized UIP regression. We then show that adding term structure information of options-implied moments further improves the explanatory power. Our results highlight the importance of expectations and risk in explaining currency returns and suggest that this information may be particularly useful during a crisis period. Chapter 2 studies the term structure of currency risk using FX options data, and finds it able to explain the cross-sectional variation of currency excess returns. With the tool of a new FX risk index, "FCX", I look into currency risk term structure and measure its shape by level and slope. I consistently find that for currencies paired by US dollars, the term structure of currency risk is flat at a low level prior to the 2008 crisis, upward-sloping after the crisis and peaks at a high level with a prominently negative slope during the crisis. This work is believed to be new in the currency research field. I then use this information to build trading strategies, earning a profit by longing currencies with the highest level or slope and shorting ones with the lowest level or slope. The profit by sorting slope is significantly high and robust to the 2008 crisis period, with a low correlation to the Carry Trade return, suggesting extra information in risk than the interest rate. Next, I extract global risk factors by level and slope to help understand the currency excess return, a long-lasting puzzle. The global risk factor by level substantially improves the cross-sectional explanatory power in currency excess returns compared to Lustig et al. (2011). Furthermore, I show that there is certain high risk corresponding to a high level and low slope, and high interest rate currency earns returns co-varying negatively to this risk, implying that it is a risky asset and thus requires a high risk premium, which explains the Carry Trade return well. Chapter 32 explores the possible macroeconomic connection in currency markets through the channel of FX risk term structure. There is a consensus in the literature that exchange rates are empirically “disconnected” from fundamentals, but a possible theoretical insight is that macroeconomic volatility shocks induce time-varying risks in the exchange rates. This chapter empirically investigates the connection between macroeconomic fundamentals and time-varying currency risks captured by the FX risk term structure, following the main findings of chapters 1 and 2. This chapter use both a small dataset of directly observable, country-specific key macroeconomic and international variables implied by exchange rate structural modeling and a small number of macroeconomic factors constructed from a large dataset of 126 U.S. macroeconomic series by principal component analysis. We perform a VAR analysis to examine impulse responses of FX risk term structure to the shocks of macroeconomic events and find that production variables can generate a relatively consistent and systematic impact pattern, which suggests potential macroeconomic connection. We also perform a direct single regression, regressing the 126 macroeconomic series of eight different groups on the FX risk term structure and apply the group LASSO technique for variable selection. Variables among both macroeconomic fundamentals and financial series are commonly selected, which suggests that financial markets’ co-movements also exist besides potential macroeconomic connection.

This thesis contributes to three major fields in the international finance literature: forward premium anomaly, monetary policy and exchange rate determination, and measuring monetary policy expectations from asset prices. In the first chapter, I develop a production-based asset pricing model predicting that excess returns of currency carry trade compensate investors for the commodity price risk. Commodity producers differ in their exposure to the export price risk. Exchange rate-commodity price covariance, procyclical interest rates, negative price of exchange rate volatility, and countercyclical currency risk premium arise endogenously. Empirically, risk factors implied by the model explain up to 55% of time-series variation in carry trade returns across developed countries, and generate substantial risk- and transaction costs-adjusted returns as tradable strategies. In the second chapter (jointly with Igor Pozdeev), we document a drift in exchange rates before monetary policy changes across major economies. Currencies tend to depreciate by 0.8% over ten days before policy rate cuts and appreciate by 0.5% before policy rate increases. We show that available fixed income instruments allow to forecast monetary policy decisions and thus that the drift is exploitable by investors. Buying (selling) currencies ten days in advance of predicted target rate hikes (cuts) earns on average a statistically significant excess return of over 40 basis points per ten-day period after trading costs. We further demonstrate that this return is robust to the choice of holding horizon and monetary policy forecast rule. Our results thus pose a major challenge for the risk-based explanations of the exchange rate dynamics. In the third chapter (jointly with Igor Pozdeev), we document overnight index swaps (OIS) to be unbiased predictors of future short rates in developed economies, bearing no significant risk premium for maturities up to one year. We.

This thesis contributes to three major fields in the international finance literature: forward premium anomaly, monetary policy and exchange rate determination, and measuring monetary policy expectations from asset prices. In the first chapter, I develop a production-based asset pricing model predicting that excess returns of currency carry trade compensate investors for the commodity price risk. Commodity producers differ in their exposure to the export price risk. Exchange rate-commodity price covariance, procyclical interest rates, negative price of exchange rate volatility, and countercyclical currency risk premium arise endogenously. Empirically, risk factors implied by the model explain up to 55% of time-series variation in carry trade returns across developed countries, and generate substantial risk- and transaction costs-adjusted returns as tradable strategies. In the second chapter (jointly with Igor Pozdeev), we document a drift in exchange rates before monetary policy changes across major economies. Currencies tend to depreciate by 0.8% over ten days before policy rate cuts and appreciate by 0.5% before policy rate increases. We show that available fixed income instruments allow to forecast monetary policy decisions and thus that the drift is exploitable by investors. Buying (selling) currencies ten days in advance of predicted target rate hikes (cuts) earns on average a statistically significant excess return of over 40 basis points per ten-day period after trading costs. We further demonstrate that this return is robust to the choice of holding horizon and monetary policy forecast rule. Our results thus pose a major challenge for the risk-based explanations of the exchange rate dynamics. In the third chapter (jointly with Igor Pozdeev), we document overnight index swaps (OIS) to be unbiased predictors of future short rates in developed economies, bearing no significant risk premium for maturities up to one year. We.

This paper presents a rule for foreign exchange interventions (FXI), designed to preserve financial stability in floating exchange rate arrangements. The FXI rule addresses a market failure: the absence of hedging solution for tail exchange rate risk in the market (i.e. high volatility). Market impairment or overshoot of exchange rate between two equilibria could generate high volatility and threaten financial stability due to unhedged exposure to exchange rate risk in the economy. The rule uses the concept of Value at Risk (VaR) to define FXI triggers. While it provides to the market a hedge against tail risk, the rule allows the exchange rate to smoothly adjust to new equilibria. In addition, the rule is budget neutral over the medium term, encourages a prudent risk management in the market, and is more resilient to speculative attacks than other rules, such as fixed-volatility rules. The empirical methodology is backtested on Banco Mexico’s FXIs data between 2008 and 2016.