Estimates of Foreign Exchange Risk Premia: A Pricing Kernel Approach

The goal of this study is to measure market prices of risk and the associated foreign exchange risk premia extending the approach proposed by Balduzzi and Robotti (2001) to an international framework. Estimations of minimum variance stochastic discount factors permits the determination of market prices of risk, which, in turn, in an international framework, allow to compute foreign exchange risk premia. Market prices of risk are time-varying and surge during financial turmoil. This may be interpreted as an increase of the investors' coefficient of risk aversion during turbulent financial markets. Foreign exchange risk premia are also time-varying and they exhibit most variation from the early '70s onwards, when the Bretton Wood exchange rate system collapsed.Foreign exchange, Risk premia, Pricing kernel

Liquidity Traps: How to Avoid Them and How to Escape Them

The paper considers ways of avoiding a liquidity trap and ways of getting out of one. Unless lower short nominal interest rates are associated with significantly lower interest volatility, a lower average rate of inflation, which will be associated with lower expected nominal interest rates, increases the odds that the zero nominal interest rate floor will become a binding constraint. The empirical evidence on this issue is mixed. Once in a liquidity trap, there are two means of escape. The first is to use expansionary fiscal policy. The second is to lower the zero nominal interest rate floor. This second option involves paying negative interest on government 'bearer bonds' -- coin and currency, that is 'taxing money', as advocated by Gesell. This would also reduce the likelihood of ending up in a liquidity trap. Taxing currency amounts to having periodic 'currency reforms', that is, compulsory conversions of 'old' currency into 'new' currency, say by stamping currency. The terms of the conversion can be set to achieve any positive or negative interest rate on currency. There are likely to be significant shoe leather costs associated with such schemes. The policy question then becomes how much shoe leather it takes to fill an output gap? Finally the paper develops a simple analytical model showing how the economy can get into a liquidity trap and how Gesell money is one way of avoiding it or escaping from it.

Recovering risk aversion from options

Cross-sections of option prices embed the risk-neutral probability densities functions (PDFs) for the future values of the underlying asset. Theory suggests that risk-neutral PDFs differ from market expectations due to risk premia. Using a utility function to adjust the risk-neutral PDF to produce subjective PDFs, we can obtain measures of the risk aversion implied in option prices. Using FTSE 100 and S&P 500 options, and both power and exponential utility functions, we show that subjective PDFs accurately forecast the distribution of realizations, while risk-neutral PDFs do not. The estimated coefficients of relative risk aversion are all reasonable. The relative risk aversion estimates are remarkably consistent across utility functions and across markets for given horizons. The degree of relative risk aversion declines with the forecast horizon and is lower during periods of high market volatility.Options (Finance) ; Prices

Overcoming the zero bound : Gesell vs. Eisler. Discussion of Mitsuhiro Fukao's "The effects of 'Gesell' (currency) taxes in promoting Japan's economic recovery".

Despite the zero lower bound on the short nominal interest rate in Japan having become a binding constraint, conventional monetary policy in Japan, in the form of generalised open market purchases of government securities of all maturities, has never been pushed to the limit where all outstanding government debt and all current and anticipated future government deficits are (or are confidently expected to be) monetised. Open market purchases of private securities can create serious governance problems. Two ways of overcoming the zero lower bound constraint have been proposed. The first is Gesell’s carry tax on currency. The second is Eisler’s proposal for the unbundling of the medium of exchange/means of payment function and the numéraire function of money through the creation of a parallel virtual currency. This raises the fundamental issue of who chooses or what determines the numéraire used in private wage and price contracts—an issue that is either not addressed in the literature or addressed incorrectly. On balance, Gesell’s proposal appears to be the more robust of the two.

Testing the stability of implied probability density functions

Implied probability density functions (PDFs) estimated from cross-sections of observed options prices are gaining increasing attention amongst academics and practitioners. However, to date little attention has been paid to the robustness of these estimates or to the confidence users can place in the summary statistics, for example skewness or the 99th percentile, derived from fitted PDFs. This paper begins to address these questions by examining the absolute and relative robustness of two of the most common methods for estimating implied smile methods. The changes resulting from randomly perturbing quoted prices by no more than a half tick provide a lower bound on the confidence intervals of the summary statistics derived from the estimated PDFs. Test are conducted using options contracts tied to Short Sterling futures and the FTSE 100 index--both trading on the London International Financial Futures Exchange. Our test show that the smoothed implied volatility smile method dominates the double-lognormal as a technique for estimating implied PDFs when average goodness-of-fits are comparable for both methods.Stocks ; Prices

Summary statistics of option-implied probability density functions and their properties

The statistics that summarise probability density functions(pdfs) implied from option prices can be used to assess market expectations about future uncertainty, asymmetry and the probability of extreme movements in asset prices. A time-series analysis of these statistics for equity index and interest rate markets provides some stylised facts about the behaviour of these elements of market expectations, their historical distribution, similarity and relative stability. Relationships between them and movements in underlying asset prices are considered. Cross-asset and cross-country comparisons and the information content of the implied pdfs for future macroeconomic and financial variables are also assessed.Options; implied probability density functions (pdfs); summary statistics; implied volatility; implied asymmetry; market expectations.