I propose a model-free method to derive forward-looking betas to currency portfolios from cross-pair currency options. Using the dollar factor---an equal-weighted basket of foreign currencies against the U.S. dollar---as the systematic factor, I find that these option-implied betas are significantly better predictors of realized betas and currency excess returns compared to traditional rolling window betas. Constructing portfolios based on option-implied betas leads to a significantly positive relation between ex-ante betas and ex-post portfolio returns, whereas there is an insignificant relation when historical betas are used.
Keywords: Exchange rates, risk premiums, currency options, option-implied betas
Quanto CDS spreads are differences between premiums of CDS contracts written on the same underlying but with different currency denominations. Such spreads can arise in arbitrage-free models and depend on the risk of a jump in the exchange rate upon default of the reference name and on the correlation between the FX-rate and the intensity of default. We develop a model that separates the contribution of these two effects to quanto spreads and apply it to four Euro area sovereigns. We also investigate to what extent quanto spreads can explain differences in yields of sovereign bonds issued by the same country in different currencies and point out that comparing bond prices across currency denominations using standard FX forward hedges misses the correlation component in quanto spreads.
Keywords: Sovereign credit risk, CDS premiums, currency risk, systemic risk
I show that volatility risk of the dollar factor---an equally weighted basket of developed U.S. dollar exchange rates---carries a significant risk premium and that it is priced in the cross-section of currency volatility excess returns. The dollar factor volatility risk premium is negative on average with an upward sloping and concave term structure. Consistent with this pattern, I find that dollar factor volatility risk is most significantly priced in the cross-section of volatility excess returns at shorter maturities. A trading strategy that sells (buys) volatility insurance on currencies with high (low) exposure to dollar factor volatility risk delivers high mean excess returns and Sharpe ratios. At shorter maturities, the profitability of this strategy cannot be explained by exposure to traditional currency factors, equity factors, or currency volatility carry factors.
Keywords: Volatility risk premia, factor models, foreign exchange volatility, currency options, option-implied betas