Essays on currency markets

Sammanfattning: This doctoral dissertation comprises three independent essays which cover different aspects of the currency market.The first paper, Long-run and short-run risk premium in currency market, investigates the risk premium of the long-run and short-run volatility component of exchange rate returns in the currency market. The results indicate that the risk price of long-run volatility innovation is significant and negative, whereas short-run volatility innovation has no effect on the carry trade returns. This result implies that investors require higher risk premiums to hold the high interest rate currencies under times of high uncertainty. In terms of a momentum strategy, the risk price of short-run volatility innovation is statistically and negatively significant, whereas the risk price of long-run innovation is insignificant. Therefore, long-run volatility cannot explain high returns of currency under the momentum strategy. High momentum returns, on the other hand, reward investors to bear the short-run volatility risk.The second paper, Central bank communication and asset correlations, examines the effect of Fed and ECB communications on the long-run stock-bond and stock-FX correlations. The paper demonstrates that negative tone in central banks’ communications results in a more negative stock-bond correlation, which supports the flight-to-quality phenomenon in both the U.S. and Euro areas. In contrast, results for stock-FX correlations are mixed. The Fed’s negative sentiment leads to opposite movements of U.S. stock prices and the U.S. dollar, whereas ECB’s negative sentiment drives Euro-area stock prices and EUR moving in the same direction. This result documents for the safe haven property of the U.S. dollar.The third paper, Can pre-FOMC predict exchange rates?, studies the predict power of text data for the EURUSD exchange rate returns on scheduled Federal Reserve Committee (FOMC) meeting days. We use text data from Dow Jones Newswire to measure hawkish-dovish sentiment scores before FOMC events. Then we use this score to predict post-FOMC policy rate changes and EURUSD exchange rate movements. Our empirical results show that pre-FOMC hawkish-dovish scores can predict policy rate changes. In addition, the U.S. dollar depreciates against the EUR if pre-FOMC news signals a rate cut and the U.S. dollar appreciates against the EUR if pre-FOMC news signals a rate hike. EURUSD exchange rate movements conditioned on pre-FOMC news are asymmetric: The absolute returns of EURUSD on dovish days are higher than those on hawkish days. We also document that a trading strategy based on pre-FOMC news exhibits economically and statistically high returns on FOMC days.