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The pricing of unexpected volatility in the currency market

journal contribution
posted on 2023-01-17, 10:40 authored by Wenna Lu, Laurence Copeland, Yongdeng Xu

Working Paper 

 Many recent papers have investigated the role played by volatility in determining the cross-section of currency returns. This paper employs two time-varying factor models: a threshold model and a Markov-switching model to price the excess returns from the currency carry trade. We show that the importance of volatility depends on whether the currency markets are unexpectedly volatile. Volatility innovations during relatively tranquil periods are largely unrewarded in the market, whereas during the volatile period, this risk, has a substantial impact on currency returns. The empirical results show that the two time-varying factor models fit the data better and generate a smaller pricing errors than the linear model, while the Markov-switching model outperforms the threshold factor models not only by generating lower pricing errors but also distinguishing two regimes endogenously and without any predetermined state variables. 

History

Published in

The European Journal of Finance

Publisher

Taylor & Francis

Version

  • AM (Accepted Manuscript)

Citation

Lu, Wenna & Copeland, Laurence & Xu, Yongdeng,(2023) "The Pricing of Unexpected Volatility in the Currency Market," The European Journal of Finance. doi: 10.1080/1351847X.2023.2190464

Print ISSN

1351-847X

Electronic ISSN

1466-4364

Cardiff Met Affiliation

  • Cardiff School of Management

Cardiff Met Authors

Wenna Lu

Cardiff Met Research Centre/Group

  • Welsh Centre for Business and Management Research

Copyright Holder

  • © The Publisher

Language

  • en

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