Hostname: page-component-78c5997874-xbtfd Total loading time: 0 Render date: 2024-11-15T11:47:55.516Z Has data issue: false hasContentIssue false
  • English
  • Français

Global Political Risk and Currency Momentum

Published online by Cambridge University Press:  08 October 2018

Ilias Filippou ,
Arie E. Gozluklu  and
Mark P. Taylor
Get access Rights & Permissions [Opens in a new window]

Abstract

Using a measure of political risk, relative to the United States, that captures unexpected political conditions, we show that political risk is priced in the cross section of currency momentum and contains information beyond other risk factors. Our results are robust after controlling for transaction costs, reversals, and alternative limits to arbitrage. The global political environment affects the profitability of the momentum strategy in the foreign exchange market; investors following such strategies are compensated for the exposure to the global political risk of those currencies they hold, that is, the past winners, and exploit the lower returns of loser portfolios. The risk compensation is mainly justified by the different exposures of foreign currencies in the momentum portfolio to U.S. political shocks, which is the main component of global political risk.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 53 , Issue 5 , October 2018 , pp. 2227 - 2259
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2018 

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

Footnotes

1

We thank Paul Malatesta (the editor) and Yuhang Xing (the referee) for helpful and constructive comments on a previous version of this paper. We are also grateful to Philippe Dupuy (discussant), Gikas Hardouvelis, Mohammad Jahan-Parvar, Eylem Ersal Kiziler, Dong Lou, Michael Moore, Aline Muller (discussant), Vikram Nanda, Alessandro Palandri, Evgenia Passari, Paolo Porchia (discussant), George Skiadopoulos, Alex Stremme, Christian Wagner and Chishen Wei (discussant) as well as seminar participants at the 2015 Georgetown Center of Economic Research (GCER), the 2015 China International Conference in Finance, the 2015 Finance Forum, the 2015 FMA European conference, the 2015 International Conference of the French Finance Association, Manchester Business School and the University of Piraeus for very useful comments. Filippou thanks the Economic and Social Research Council (ESRC) as well as the University of Warwick Business School for the financial support.

References

Addoum, J. M., and Kumar, A.. “Political Sentiment and Predictable Returns.” Review of Financial Studies, 29 (2016), 3471–3518.Google Scholar
Akram, Q. F.; Rime, D.; and Sarno, L.. “Arbitrage in the Foreign Exchange Market: Turning on the Microscope.” Journal of International Economics, 76 (2008), 237–253.Google Scholar
Alesina, A., and Tabellini, G.. “External Debt, Capital Flight and Political Risk.” Journal of International Economics, 27 (1989), 199–220.Google Scholar
Aliber, R. Z.“The Interest Rate Parity Theorem: A Reinterpretation.” Journal of Political Economy, 81 (1973), 1451–1459.Google Scholar
Andrews, D. W. K.“Heteroskedasticity and Autocorrelation Consistent Covariance Matrix Estimation.” Econometrica, 59 (1991), 817–858.Google Scholar
Ang, A.; Hodrick, R. J.; Xing, Y.; and Zhang, X.. “The Cross-Section of Volatility and Expected Returns.” Journal of Finance, 61 (2006), 259–299.Google Scholar
Asness, C. S.; Moskowitz, T. J.; and Pedersen, L. H.. “Value and Momentum Everywhere.” Journal of Finance, 68 (2013), 929–985.Google Scholar
Bae, J. W., and Elkamhi, R.. “Global Equity Correlation in FX Carry and Momentum Trades.” Available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2521608 (2017).Google Scholar
Bailey, W., and Chung, Y. P.. “Exchange Rate Fluctuations, Political Risk, and Stock Returns: Some Evidence from an Emerging Market.” Journal of Financial and Quantitative Analysis, 30 (1995), 541–561.Google Scholar
Baker, S. R.; Bloom, N.; and Davis, S. J.. “Measuring Economic Policy Uncertainty.” Quarterly Journal of Economics, 131 (2016), 1593–1636.Google Scholar
Bank for International Settlements. Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity in 2013. Basel, Switzerland: Bank for International Settlements Press(2013).Google Scholar
Barroso, P., and Santa-Clara, P.. “Momentum Has Its Moments.” Journal of Financial Economics, 116 (2015), 111–120.Google Scholar
Bauer, M. D.; Rudebusch, G. D.; and Wu, J. C.. “Term Premia and Inflation Uncertainty: Empirical Evidence from an International Panel Dataset: Comment.” American Economic Review, 104 (2014), 323–337.Google Scholar
Bekaert, G.; Harvey, C. R.; Lundblad, C. T.; and Siegel, S.. “Political Risk Spreads.” Journal of International Business Studies, 45 (2014), 471–493.Google Scholar
Belo, F.; Gala, V. D.; and Li, J.. “Government Spending, Political Cycles, and the Cross Section of Stock Returns.” Journal of Financial Economics, 107 (2013), 305–324.Google Scholar
Bennedsen, M., and Zeume, S.. “Corporate Tax Havens and Transparency.” Review of Financial Studies, 31 (2017), 1221–1264.Google Scholar
Blomberg, S. B., and Hess, G. D.. “Politics and Exchange Rate Forecasts.” Journal of International Economics, 43 (1997), 189–205.Google Scholar
Boutchkova, M.; Doshi, H.; Durnev, A.; and Molchanov, A.. “Precarious Politics and Return Volatility.” Review of Financial Studies, 25 (2012), 1111–1154.Google Scholar
Boyer, B.; Mitton, T.; and Vorkink, K.. “Expected Idiosyncratic Skewness.” Review of Financial Studies, 23 (2010), 169–202.Google Scholar
Breeden, D. T.; Gibbons, M. R.; and Litzenberger, R. H.. “Empirical Tests of the Consumption-Oriented CAPM.” Journal of Finance, 44 (1989), 231–262.Google Scholar
Burnside, C.; Eichenbaum, M.; Kleshchelski, I.; and Rebelo, S.. “Do Peso Problems Explain the Returns to the Carry Trade? ” Review of Financial Studies, 24 (2011b), 853–891.Google Scholar
Burnside, C.; Eichenbaum, M.; and Rebelo, S. S.. “Carry Trade and Momentum in Currency Markets.” Annual Review of Financial Economics, 3 (2011a), 511–535.Google Scholar
Cao, W.; Duan, X.; and Uysal, V. B.. “Does Political Uncertainty Affect Capital Structure Choices?” Working Paper, University of Oklahoma (2013).Google Scholar
Cen, J., and Marsh, I. W.. “Off the Golden Fetters: Examining Interwar Carry Trade and Momentum.” Available at https://ssrn.com/abstract=2358456 (2013).Google Scholar
Chen, Z., and Petkova, R.. “Does Idiosyncratic Volatility Proxy for Risk Exposure? ” Review of Financial Studies, 25 (2012), 2745–2787.Google Scholar
Cheung, Y.-W., and Chinn, M. D.. “Currency Traders and Exchange Rate Dynamics: A Survey of the US Market.” Journal of International Money and Finance, 20 (2001), 439–471.Google Scholar
Chinn, M. D., and Ito, H.. “What Matters for Financial Development? Capital Controls, Institutions, and Interactions.” Journal of Development Economics, 81 (2006), 163–192.Google Scholar
Cochrane, J. H. Asset Pricing, rev. ed. Princeton, NJ: Princeton University Press (2005).Google Scholar
Della Corte, P.; Sarno, L.; Schmeling, M.; and Wagner, C.. “Exchange Rates and Sovereign Risk.” Available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2354935 (2016).Google Scholar
Dooley, M. P., and Isard, P.. “Capital Controls, Political Risk, and Deviations from Interest-Rate Parity.” Journal of Political Economy, 88 (1980), 370–384.Google Scholar
Fama, E. F., and MacBeth, J. D.. “Risk, Return, and Equilibrium: Empirical Tests.” Journal of Political Economy, 81 (1973), 607–636.Google Scholar
Faulkender, M., and Petersen, M.. “Investment and Capital Constraints: Repatriations under the American Jobs Creation Act.” Review of Financial Studies, 25 (2012), 3351–3388.Google Scholar
Ferson, W.; Siegel, A. F.; and Xu, P. T.. “Mimicking Portfolios with Conditioning Information.” Journal of Financial and Quantitative Analysis, 41 (2006), 607–635.Google Scholar
Filippou, I., and Taylor, M. P.. “Common Macro Factors and Currency Premia.” Journal of Financial and Quantitative Analysis, 52 (2017), 1731–1763.Google Scholar
Foley, C. F.; Hartzell, J. C.; Titman, S.; and Twite, G.. “Why Do Firms Hold So Much Cash? A Tax-Based Explanation.” Journal of Financial Economics, 86 (2007), 579–607.Google Scholar
Froot, K. A., and Thaler, R. H.. “Anomalies: Foreign Exchange.” Journal of Economic Perspectives, 4 (1990), 179–192.Google Scholar
Fu, F.“Idiosyncratic Risk and the Cross-Section of Expected Stock Returns.” Journal of Financial Economics, 91 (2009), 24–37.Google Scholar
Gao, P., and Qi, Y.. “Political Uncertainty and Public Financing Costs: Evidence from US Municipal Bond Markets.” Available at https://www3.nd.edu/∼pgao/papers/Election_20130807.pdf (2012).Google Scholar
Goyal, A., and Santa-Clara, P.. “Idiosyncratic Risk Matters!” Journal of Finance, 58 (2003), 975–1008.Google Scholar
Hansen, L. P.“Large Sample Properties of Generalized Method of Moments Estimators.” Econometrica: Journal of the Econometric Society, 50 (1982), 1029–1054.Google Scholar
Hansen, L. P., and Jagannathan, R.. “Assessing Specification Errors in Stochastic Discount Factor Models.” Journal of Finance, 52 (1997), 557–590.Google Scholar
Hodrick, R. J. The Empirical Evidence on the Efficiency of Forward and Futures Foreign Exchange Markets. Chur, Switzerland: Harwood Academic (1987).Google Scholar
Jagannathan, R., and Wang, Z.. “The Conditional CAPM and the Cross-Section of Expected Returns.” Journal of Finance, 51 (1996), 3–53.Google Scholar
Jagannathan, R., and Wang, Z.. “An Asymptotic Theory for Estimating Beta-Pricing Models Using Cross-Sectional Regression.” Journal of Finance, 53 (1998), 1285–1309.Google Scholar
Julio, B., and Yook, Y.. “Political Uncertainty and Corporate Investment Cycles.” Journal of Finance, 67 (2012), 45–83.Google Scholar
Kelly, B.; Pástor, L.; and Veronesi, P.. “The Price of Political Uncertainty: Theory and Evidence from the Option Market.” Journal of Finance, 71 (2016), 2417–2480.Google Scholar
King, M. R.; Osler, C. L.; and Rime, D.. “Foreign Exchange Market Structure, Players and Evolution.” Norges Bank Working Paper No. 2011/10 (2011).Google Scholar
Kobrin, S. J.“Political Risk: A Review and Reconsideration.” Journal of International Business Studies, 10 (1979), 67–80.Google Scholar
Lamont, O. A.“Economic Tracking Portfolios.” Journal of Econometrics, 105 (2001), 161–184.Google Scholar
Lensink, R.; Hermes, N.; and Murinde, V.. “Capital Flight and Political Risk.” Journal of International Money and Finance, 19 (2000), 73–92.Google Scholar
Lewellen, J.; Nagel, S.; and Shanken, J.. “A Skeptical Appraisal of Asset Pricing Tests.” Journal of Financial Economics, 96 (2010), 175–194.Google Scholar
Lou, D., and Polk, C.. “Comomentum: Inferring Arbitrage Activity from Return Correlations.” In Paul Woolley Centre for the Study of Capital Market Dysfunctionality, Financial Markets Group (2013).Google Scholar
Lugovskyy, J. C.“Essays on Asset Pricing and Political Risk.” Ph.D. Dissertation, University of Kansas (2012).Google Scholar
Lustig, H.; Roussanov, N.; and Verdelhan, A.. “Common Risk Factors in Currency Markets.” Review of Financial Studies, 24 (2011), 3731–3777.Google Scholar
Mancini-Griffoli, T., and Ranaldo, A.. “Limits to Arbitrage During the Crisis: Funding Liquidity Constraints and Covered Interest Parity.” Available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1569504 (2013).Google Scholar
Menkhoff, L.; Sarno, L.; Schmeling, M.; and Schrimpf, A.. “Carry Trades and Global Foreign Exchange Volatility.” Journal of Finance, 67 (2012a), 681–718.Google Scholar
Menkhoff, L.; Sarno, L.; Schmeling, M.; and Schrimpf, A.. “Currency Momentum Strategies.” Journal of Financial Economics, 106 (2012b), 660–684.Google Scholar
Mueller, P.; Stathopoulos, A.; and Vedolin, A.. “International Correlation Risk.” In Financial Markets Group, London School of Economics and Political Science (2013).Google Scholar
Neely, C. J., and Weller, P. A.. “Lessons from the Evolution of Foreign Exchange Trading Strategies.” Journal of Banking & Finance, 37 (2013), 3783–3798.Google Scholar
Newey, W. K., and West, K. D.. “A Simple, Positive Semi-Definite, Heteroskedasticity and Autocorrelation Consistent Covariance Matrix.” Econometrica, 55 (1987), 703–708.Google Scholar
Okunev, J., and White, D.. “Do Momentum-Based Strategies Still Work in Foreign Currency Markets? ” Journal of Financial and Quantitative Analysis, 38 (2003), 425–448.Google Scholar
Pástor, L., and Veronesi, P.. “Uncertainty About Government Policy and Stock Prices.” Journal of Finance, 67 (2012), 1219–1264.Google Scholar
Pástor, L., and Veronesi, P.. “Political Uncertainty and Risk Premia.” Journal of Financial Economics, 110 (2013), 520–545.Google Scholar
Rime, D., and Schrimpf, A.. “The Anatomy of the Global FX Market through the Lens of the 2013 Triennial Survey.” BIS Quarterly Review, Dec. (2013), 27–43. Available at https://www.bis.org/publ/qtrpdf/r_qt1312e.htm.Google Scholar
Sager, M. J., and Taylor, M. P.. “Under the Microscope: The Structure of the Foreign Exchange Market.” International Journal of Finance and Economics, 11 (2006), 81–95.Google Scholar
Sarno, L., and Taylor, M. P.. The Economics of Exchange Rates. Cambridge, UK: Cambridge University Press (2002).Google Scholar
Shanken, J.“Multivariate Tests of the Zero-Beta CAPM.” Journal of Financial Economics, 14 (1985), 327–348.Google Scholar
Shanken, J.“On the Estimation of Beta-Pricing Models.” Review of Financial Studies, 5 (1992), 1–55.Google Scholar
Stein, J. C.“Presidential Address: Sophisticated Investors and Market Efficiency.” Journal of Finance, 64 (2009), 1517–1548.Google Scholar
Taylor, M. P.“Covered Interest Parity: A High-Frequency, High-Quality Data Study.” Economica, 54 (1987), 429–438.Google Scholar
Taylor, M. P.“Covered Interest Arbitrage and Market Turbulence.” Economic Journal, 99 (1989), 376–391.Google Scholar
Taylor, M. P.“The Economics of Exchange Rates.” Journal of Economic Literature, 33 (1995), 13–47.Google Scholar
Taylor, M. P., and Allen, H.. “The Use of Technical Analysis in the Foreign Exchange Market.” Journal of International Money and Finance, 11 (1992), 304–314.Google Scholar
Supplementary material: File

Filippou et al. supplementary material

Filippou et al. supplementary material 1

Download Filippou et al. supplementary material(File)
File 485.5 KB