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The information content of risk reversals in emerging market currencies

Adonias Evaristo da Costa Filho

Abstract


This paper analyzes the information content of risk reversals for ten emerging
market currencies. In contrast to the findings for major developed currencies,
it is found that in some cases risk reversals (RR) are helpful in predicting
currency returns, but in general RR are predicted by but do not predict carry
trade returns. Evidence based on country vector autoregressions (VARs) and a
panel VAR (PVAR) indicate that RR react in a procyclicalway to carry returns, i.e.,
it is cheaper (more expensive) to buy protection against currency weakness after
positive (negative) total returns. All in all, it is found that crash risk accounts
for a small share of carry trade returns variance, which seems to be more related
to global risk aversion shocks. A sentiment indicator of crash risk in emerging
market currencies is highly correlated with the VIX.

Keywords


carry trade, risk reversal, exchange rate, crash risk.

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