Downside risk in stock and currency markets

This thesis consists of an introductory chapter, three main chapters, and a concluding chapter. In Chapter 2, which was nominated for an EFMA 2014 Best Paper Award, I provide a novel risk-based explanation for the profitability of global momentum strategies. I show that the performance of past winners and losers is asymmetric in states of the global market upturns and downturns. Winners have higher downside market betas and lower upside market betas than losers, and hence their risks are more asymmetric. The winner-minus-loser (WML) momentum portfolios are exposed to the downside market risk, but serve as a hedge against the upside market risk. The high returns of the WML portfolios compensate investors for their high risk asymmetry. After controlling for this risk asymmetry, the momentum portfolios do not yield significant abnormal returns, and the momentum factor becomes insignificant in the cross-section. The two-beta CAPM with downside risk explains the cross-section of returns to global momentum portfolios well. In the third chapter, published in the Review of Finance and the winner of EFMA 2013 John Doukas Best Paper Award, I propose a new factor – the global downside market factor – to explain high returns to carry trades. I show that carry trades have high downside market risk, i.e. they crash systematically in the worst states of the world when the global stock market plunges or when a disaster occurs. The downside market factor explains the returns to currency portfolios sorted by the forward discount better than other factors previously proposed in the literature. GMM estimates of the downside beta premium are similar in the currency and stock markets, statistically significant and close to their theoretical value. I show that the high returns to carry trades are fair compensation for their high downside market risk. In the fourth chapter, I study whether or not countries‟ macroeconomic characteristics are systematically related to the downside market risk of their currencies. I find that the downside risk is strongly associated with the local inflation rate, real interest rate and net foreign asset 5 position. Currencies of countries with higher inflation and real interest rates and lower (negative) net foreign asset position (debtor countries) are more exposed to the downside risk whereas currencies of countries with low inflation and real interest rates and positive net foreign asset position (creditor countries) exhibit „safe haven‟ properties. Since inflation and real interest rates determine nominal interest rates which determinecurrency returns which, in turn, determine capital flows and net foreign asset positions, these macroeconomic variables are related. But the local real interest rate has the highest explanatory power in accounting for the cross-section of currency exposure to the downside risk. This suggests that the direction of currency trading is the reason why some currencies are exposed to the downside risk more than others. High currency downside risk is a consequence of investments in high-yield risky currencies and flight from them in „hard times‟. Currencies of low-yield creditor countries, on the contrary, provide a hedge in „hard times‟ because capital flies back to them. Currency exposure to the downside market risk has increased significantly in the 2000s when the volume of currency trading by institutional investors increased.