Upside and downside correlated jump risk premia of currency options and expected returns

• Published in: Financial innovation (Heidelberg) Vol. 9; no. 1; p. 90
• Main Authors: He, Jie-Cao, Chang, Hsing-Hua, Chen, Ting-Fu, Lin, Shih-Kuei
• Format: Journal Article
• Language: English
• Published: Berlin/Heidelberg Springer Berlin Heidelberg 01.12.2023; Springer Nature B.V; SpringerOpen
• Subjects: Correlated jumps; Currency option; Economics; Economics and Finance; Interest rates; Jump-diffusion process; Macroeconomics/Monetary Economics//Financial Economics; Political Economy/Economic Systems; Risk factors; Risk premia; Risk premiums; Correlated jumps; Currency option; Risk premia; Jump-diffusion process
• ISSN: 2199-4730; 2199-4730
• DOI: 10.1186/s40854-023-00493-3

This research explores upside and downside jumps in the dynamic processes of three rates: domestic interest rates, foreign interest rates, and exchange rates. To fill the gap between the asymmetric jump in the currency market and the current models, a correlated asymmetric jump model is proposed to capture the co-movement of the correlated jump risks for the three rates and identify the correlated jump risk premia. The likelihood ratio test results show that the new model performs best in 1-, 3-, 6-, and 12-month maturities. The in- and out-of-sample test results indicate that the new model can capture more risk factors with relatively small pricing errors. Finally, the risk factors captured by the new model can explain the exchange rate fluctuations for various economic events.