Research
Published Articles
Journal of Financial Economics (2023), 149, 473-495.
This paper extends Kremens and Martin (2019) and uncovers a novel component for exchange rate predictability based on the price difference between sovereign credit default swaps denominated in different currencies. This new forecasting variable – the credit-implied risk premium – captures the expected currency depreciation conditional on a severe but rare credit event. Using data for 16 Eurozone countries, we find that the credit-implied risk premium positively forecasts the dollar-euro exchange rate return at various horizons, both in-sample and out-of-sample. A currency strategy that exploits the informative content of our predictor, moreover, generates substantial out-of-sample economic value.
Accepted for presentation at: 2020 AFA, 2020 EFA, 2018 CDI Annual Conference.
Management Science (2023), forthcoming.
This paper studies the link between currency excess returns and current account uncertainty, measured as a dispersion in current account forecasts. We find evidence that the currencies of high-yielding and net-debtor countries deliver low returns whereas the currencies of low-yielding and net-creditor countries a hedge when current account uncertainty is unexpectedly high. In contrast, forecast dispersion for other macro indicators displays no significant relation with the cross-section of currency excess returns. In addition, an increase in current account uncertainty is associated with positive (negative) future excess returns on investment (funding) currencies. This mechanism is consistent with the exchange rate theory of Gabaix and Maggiori (2015), which is based on capital flows in imperfect financial markets.
Accepted for presentation at: 2015 EFA, 2016 AFA.
Management Science (2022), 68, 5557-6354.
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.
Accepted for presentation at: 2014 EFA, 2016 Europe Inquire Conference, and 2016 AEA.
Journal of Finance (2021), 76, 2763-2803.
We relate currency mispricing originating from the breakdown of covered interest rate parity to the dealer balance-sheet constraints resulting from the post-crisis financial regulation. Using a unique dataset on contract-level foreign exchange derivatives with disclosed counterparty identities, we find that dealers with a higher leverage ratio demand an additional premium from their clients for synthetic dollar funding. We handle endogeneity using two exogenous variations associated with the public disclosure of the leverage ratio, and the introduction of the UK leverage ratio framework while controlling for changes in demand conditions at the client level.
Accepted for presentation at: 2018 VSFX, 2018 WFA, 2018 Finance Down Under, 2018 Inquire Europe Spring Seminar, 2017 EFA, 2017 Chicago Booth International Macro-Finance Conference, 2017 BIS Symposium, and 2017 Bank of Canada/Banco de Espana Workshop on International Financial Markets.
Winner of the Inquire Europe Research Grant, 2017.
Winner of the Canadian Derivatives Institute Research Grant, 2017.
Journal of Financial Economics (2021), 139, 950-970.
We identify a global risk factor in the cross-section of implied volatility returns in currency markets. A zero-cost strategy that buys forward volatility agreements with downward sloping implied volatility curves and sells those with upward slopes – volatility carry strategy – generates significant excess returns. The covariation with volatility carry returns fully explains the cross-sectional variation of our slope-sorted portfolios. The lower the slope, the more the forward volatility agreement is exposed to volatility carry risk.
Review of Financial Studies, 2016. Volume 29, pp. 2161-2193.
We show that a global imbalance risk factor that captures the spread in countries’ external imbalances and their propensity to issue external liabilities in foreign currency explains the cross-sectional variation in currency excess returns. The economic intuition is simple: net debtor countries offer a currency risk premium to compensate investors willing to finance negative external imbalances because their currencies depreciate in bad times. This mechanism is consistent with exchange rate theory based on capital flows in imperfect financial markets. We also find that the global imbalance factor is priced in cross-sections of other major asset markets.
Winner of the Kepos Capital Award, Best Paper on Investments at the WFA, 2013.
Winner of the Inquire Europe Research Grant, 2013.
Journal of Financial Economics, 2016. Volume 120, pp. 21-40.
We discover a new currency strategy with highly desirable return and diversification properties, which uses the predictive ability of currency volatility risk premia for currency re- turns. The volatility risk premium—the difference between expected realized volatility and model-free implied volatility—reflects the costs of insuring against currency volatility fluctuations. The strategy sells high insurance-cost currencies and buys low insurance-cost currencies. A distinctive feature of the strategy’s returns is that they are mainly generated by movements in spot exchange rates instead of interest rate differentials. We explore explanations for the profitability of the strategy, which cannot be understood using traditional risk factors.
“The Predictive Information Content of External Imbalances for Exchange Rate Returns: How Much Is It Worth?” (with L. Sarno and G. Sestieri).
Review of Economics and Statistics, 2012. Volume 94, pp. 100-115.
This paper examines the exchange rate predictability stemming from the equilibrium model of international financial adjustment developed by Gourinchas and Rey (2007). Using predictive variables that measure cyclical external imbalances for country pairs, we assess the ability of this model to forecast out-of-sample four major U.S. dollar exchange rates using various economic criteria of model evaluation. The analysis shows that the model provides economic value to a risk-averse investor, delivering substantial utility gains when switching from a portfolio strategy based on the random walk benchmark to one that conditions on cyclical external imbalances.
Winner of the Inquire UK Best Paper Award, 2011.
Winner of the Inquire UK Grant.
Journal of Financial Economics, 2011. Volume 100, pp. 496-513.
This paper investigates the empirical relation between spot and forward implied volatility in foreign exchange. We formulate and test the forward volatility unbiasedness hypothesis, which may be viewed as the volatility analogue to the extensively researched hypothesis of unbiasedness in forward exchange rates. Using a new dataset of spot implied volatility quoted on over-the-counter currency options, we compute the forward implied volatility that corresponds to the delivery price of a forward contract on future spot implied volatility. This contract is known as a forward volatility agreement. We find strong evidence that forward implied volatility is a systematically biased predictor that overestimates movements in future spot implied volatility. This bias in forward volatility generates high economic value to an investor exploiting predictability in the returns to volatility speculation and indicates the presence of predictable volatility term premiums in foreign exchange.
Winner of the Inquire UK Best Paper Award, 2010
“A Century of Equity Premium Predictability and the Consumption-Wealth Ratio: An International Perspective” (with L. Sarno and G. Valente).
Journal of Empirical Finance, 2010. Volume 17, pp. 313-331.
This paper re-examines the predictive ability of the consumption–wealth ratio (cay) on the equity premium using hand-collected annual data spanning one century for four major economies. In addition to statistical tests of out-of-sample forecast accuracy, we measure the economic value of the predictive information in cay in a stylized asset allocation strategy. We find that cay does not contain predictive power prior to World War II, when a structural break occurs for all countries. In the postwar period, while statistical tests provide mixed evidence, economic criteria uncover substantial predictive power in cay, further enhanced when allowing for economically meaningful restrictions.
Review of Financial Studies, 2009. Volume 22, pp. 3491-3530.
This paper provides a comprehensive evaluation of the short-horizon predictive ability of economic fundamentals and forward premiums on monthly exchange-rate returns in a framework that allows for volatility timing. We implement Bayesian methods for estimation and ranking of a set of empirical exchange rate models, and construct combined forecasts based on Bayesian model averaging. More importantly, we assess the economic value of the in-sample and out-of-sample forecasting power of the empirical models, and find two key results: (1) a risk-averse investor will pay a high performance fee to switch from a dynamic portfolio strategy based on the random walk model to one that conditions on the forward premium with stochastic volatility innovations and (2) strategies based on combined forecasts yield large economic gains over the random walk benchmark. These two results are robust to reasonably high transaction costs.
“The Expectation Hypothesis of the Term Structure of Very Short-term Rates: Statistical Tests and Economic Value” (with L. Sarno and D.L. Thornton).
Journal of Financial Economics, 2008. Volume, 89, pp. 158-174.
This paper reexamines the validity of the expectation hypothesis (EH) of the term structure of US repo rates ranging in maturity from overnight to 3 months. We extend the work of Longstaff [2000b. The term structure of very short term rates: new evidence for the expectations hypothesis. Journal of Financial Economics 58, 397–415] in two directions: (1) we implement statistical tests designed to increase test power in this context; (2) more important, we assess the economic value of departures from the EH based on criteria of profitability and economic significance in the context of a simple trading strategy. The EH is rejected throughout the term structure examined on the basis of the statistical tests. However, the results of our economic analysis are favorable to the EH, suggesting that the statistical rejections of the EH in the repo market are economically insignificant.
Handbook Chapters
Della Corte, P., and I. Tsiakas (2013). “Statistical and Economic Methods for Evaluating Exchange Rate Predictability,” Handbook of Exchange Rates, London: Wiley.
This chapter provides a comprehensive review of the statistical and economic methods used for evaluating out-of-sample exchange rate predictability. We illustrate these methods by assessing the forecasting performance of a set of widely used empirical exchange rate models using monthly returns on nine major US dollar exchange rates. We find that empirical models based on uncovered interest parity, purchasing power parity and the asymmetric Taylor rule perform better than the random walk in out-of-sample forecasting using both statistical and economic criteria. We also confirm that conditioning on monetary fundamentals does not generate out-of-sample economic value. Finally, combined forecasts formed using a variety of model averaging methods perform better than individual empirical models. These results are robust to reasonably high transaction costs, the choice of numeraire and the exclusion of any one currency from the investment opportunity set.
Della Corte, P., L. Sarno, and I. Tsiakas (2013). “Volatility and Correlation Timing in Active Currency Management,” Handbook of Exchange Rates, London: Wiley.
This chapter examines how dynamic volatilities and correlations in exchange rate returns affect the optimal portfolio choice of a risk-averse investor engaging in international asset allocation. We take a Bayesian approach in estimation and asset allocation that accounts for parameter and model uncertainty, and find substantial economic value in both volatility and correlation timing. This result is robust to reasonable transaction costs, parameter and model uncertainty, and alternative specifications for volatilities and correlations.