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Essays on foreign exchange risk

Kremens, Lukas (2019) Essays on foreign exchange risk. PhD thesis, The London School of Economics and Political Science (LSE).

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Abstract

This dissertation consists of three chapters examining three different dimensions of foreign exchange risk. In chapter one, I deal with currency redenomination risk in the Eurozone, that is, the risk that euros held in a particular Eurozone country are converted into a new national currency once the country leaves the currency union. This conversion exposes holders of euro-denominated assets in that country to foreign exchange risk. I extract empirical measures of redenomination risk from asset prices and show that redenomination risk in France and Italy spikes around plebiscites in 2017 and 2018. French redenomination risk is associated with redenomination risk in other Eurozone countries, while Italian redenomination risk does not co-move with similar risks in other countries. These results are consistent with the interpretation that a French|unlike an Italian|exit from the Eurozone is associated with a Eurozone break-up. Chapter two is conjoint work with Ian Martin. We present a new identity that relates expected exchange rate appreciation to the currency's (risk-neutral) covariance with equity markets, and use it to motivate a currency forecasting variable based on the prices of quanto index contracts. We show via panel regressions that the quanto forecast variable is an economically and statistically significant predictor of currency appreciation and of excess returns on currency trades. Out of sample, the quanto variable outperforms predictions based on uncovered interest parity, on purchasing power parity, and on a random walk as a forecaster of differential (dollar-neutral) currency appreciation. In the third chapter, as in chapter two, I examine the exposures of different currencies to equity market risk. In contrast to the second chapter, chapter three analyses the link between risk exposures and speculative trading patterns, rather than measuring conditional risk exposures to forecast returns. I find, in a post-crisis sample, that currencies are more positively correlated with equity market returns, when hedge funds are long the currency future and vice versa for short positions.

Item Type: Thesis (PhD)
Additional Information: © 2019 Lukas Kremens
Library of Congress subject classification: H Social Sciences > HD Industries. Land use. Labor > HD61 Risk Management
H Social Sciences > HG Finance
Sets: Departments > Finance
Supervisor: Martin, Ian and Ferreira, Daniel
URI: http://etheses.lse.ac.uk/id/eprint/3909

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