The predictive power of currency tails
Currency tails can explain and predict the evolution of the currency risk premium.
In this work we show how currency options can be used to extract information regarding higher moments of the underlying foreign exchange rate and synthesize variance and currency swaps. These contracts can be used to manage variance and skew currency risks. We explain how these contacts can be broken down so that the information contained in the tails of the currency distribution can be extracted.
Quite surprisingly, these tails can explain and predict the evolution of the currency risk premium far better than the commonly used financial factors. These results underline a unique feature of the currency market, which contrasts with the other asset classes, namely that both tails carry information regarding crash risk.
This overview is based on the paper entitled “Semivariance and semiskew risk premiums in currency markets”, authored by José Da Fonseca and Edem Dawui, and is published in Journal of Futures Market ( http://dx.doi.org/10.1002/fut.22160 )