Award-Winning Paper Evaluates Downside Risk in International Financial Markets

Foreign exchange is seen as a potentially risky investment and there has been ongoing debate on whether currency returns can be explained by their association with risk factors. In the paper, “Conditional Risk Premia in Currency Markets and Other Asset Classes,” Matteo Maggiori, assistant professor of finance at the Stern School of Business and affiliated assistant professor in NYU’s Department of Economics, and his co-authors, Martin Lettau and Michael Weber from the University of California Berkeley Haas School of Business, found that the cross section of currency returns can be explained by a risk model in which investors are concerned about downside risk.

According to the researchers, the downside risk capital asset-pricing model (DR-CAPM) can price the cross section of currency returns. High-yield currencies earn higher excess returns than low-yield currencies because their co-movement with aggregate market returns is stronger conditional on bad market returns. They found that similar patterns hold in other common asset classes such as equities and equity options, commodities, and sovereign bonds. The DR-CAPM offers a unified risk view of all these asset classes. Such unified treatment of investment across asset classes had proven elusive in the academic literature and has relevant implications for the theory and practice of investment.

The researchers were presented with the second annual AQR Insight Award for this paper in May 2013. The $100,000 award, sponsored by AQR Capital Management, recognizes unpublished papers that provide significant new practical insights to institutional investors.

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