Essays in international finance

Zhang, Zhekai (2020) Essays in international finance. PhD thesis, University of Glasgow.

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In this PhD thesis, I first critically review some key findings for the currency market studies throughout the past two decades. Two strands of literature, namely the microstructure approach and risk-based approach, has been found to fit well with the empirical puzzle of the forward premium of foreign exchange rates. I then follow these two strands of literature to discuss the risk premiums on the currency market. This PhD thesis is centred around the following two important issues.

1. The market microstructure and risk-based approach are based on different visions of the model economy. Are the empirical facts in support of two strands of literature consistent with both?

The second chapter studies how the microstructure approach and risk-based approach are consistent with each other. I follow the risk-based framework of asset pricing models to propose a set of pricing factors that are motivated by microstructure models. I use the forward premium sign-adjusted cross-sectional average of standardized order flow to provide a direct measure of buying and selling pressure to carry trade strategy. This factor explains most of the cross-sectional variations of currency portfolios and appears to be a good proxy for currency carry trade crash risk. The high value of this factor corresponds with high on-going carry trade positions, and it also associates with a high probability of the investors' unwinding of their carry trade positions which causes currency carry trade crashes. Similarly, the past return signed order flow factor is also proposed to price most of the cross-sectional variations of currency momentum portfolios.

Additionally, a set of factor constructed from the disaggregated order flow data by four customer types: Asset Manager (AM), Hedge Fund (HF), Corporate (CO) and Private Client (PC) shows different correlation pattern and explanation power for currency portfolios. In particular, it appears that financial customers (AM and HF) are risk-takers while non-financial customers (CO and PC) serve as liquidity providers.

I bring two strands of literature closer by using market microstructure motivated factors to price the currency carry and momentum anomalies.

2. None of the model proposed in the literature is compatible with both carry and momentum anomaly on the currency market. Is currency momentum anomaly related to the carry trade anomaly?

Chapter three focuses on the risk characteristics of the currency momentum anomaly. It provides a detailed analysis of its dynamic risk exposure to currency factors. I find that currency momentum betas to the 'carry trade high minus low' (HML) factor are conditioned on the previous and contemporaneous carry trade returns. Unconditional currency momentum beta to HML is not significant. However, under a bear carry trade state (previous carry trade return is negative), the momentum beta to HML is negative. If the contemporaneous carry trade returns are positive under bear carry trade state, the beta is further decreased.

This risk pattern explains the asymmetric written call-option-like payoff and rare crashes of the currency momentum strategies. I show that currency momentum strategies crash following a bear carry trade market state when volatilities of HML and DOL are high, in particular, when the carry trade is recovering from previous drawdowns. I also detected a significant dynamic beta pattern of currency momentum to the 'dollar risk factor' (DOL). However, dynamic exposures to DOL is symmetric. Thus, it does not result in the momentum crash.

By using the insight of the dynamic risk exposure pattern of currency momentum, I build a dynamic momentum strategy that could hedge the possible momentum crashes which provide high returns and Sharp ratios with positive sample skewness.

Item Type: Thesis (PhD)
Qualification Level: Doctoral
Keywords: International finance, asset pricing, foreign exchange, market microstructure, carry trade, momentum.
Subjects: H Social Sciences > HG Finance
Colleges/Schools: College of Social Sciences > Adam Smith Business School > Economics
Supervisor's Name: Cerrato, Prof. Mario and Burnside, Prof. Craig
Date of Award: 2020
Depositing User: Dr. Zhekai Zhang
Unique ID: glathesis:2020-81364
Copyright: Copyright of this thesis is held by the author.
Date Deposited: 18 May 2020 12:30
Last Modified: 18 May 2020 12:42

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