International Finance Discussion Papers (IFDP)

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February 2017

Uncertainty, Currency Excess Returns, and Risk Reversals

Lucas Husted, John Rogers, and Bo Sun

Abstract:

In this paper we provide strong evidence that heightened uncertainty in the U.S. real economy or financial markets significantly raises excess returns to the currency carry trade. We posit that this works through the influence of uncertainty on global investors' risk preferences. Macro and financial uncertainty also lower foreign exchange risk reversals, an effect that is particularly strong for high interest rate portfolios. Our results are consistent with the idea that an increase in uncertainty regarding the U.S. economy or financial markets increases investors' risk aversion, which in turn drives up the expected returns and the cost of protection against crash risk in the FX market.

Keywords: Exchange rates, uncovered interest parity, uncertainty

DOI: https://doi.org/10.17016/IFDP.2017.1196

PDF: Full Paper

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Last Update: January 09, 2020