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Measuring the Subjective Value of Risky and Ambiguous Options using Experimental Economics and Functional MRI Methods
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Sovereign default network and currency risk premia.

Lu Yang1, Lei Yang2, Xue Cui1

  • 1College of Economics, Shenzhen University, 3688 Nanhai Avenue, Nanshan District, Shenzhen, 518060 Guangdong People's Republic of China.

Financial Innovation
|May 16, 2023
PubMed
Summary

This study reveals network centrality in sovereign credit default swap markets predicts currency risk premia. A novel trading strategy based on network analysis outperforms traditional currency momentum strategies.

Keywords:
Currency risk premiaHigh-dimensional networkLASSOSovereign CDS

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Area of Science:

  • Economics
  • Financial Markets
  • Network Analysis

Background:

  • Sovereign credit default swap (CDS) markets exhibit complex interconnectedness.
  • Understanding network properties is crucial for predicting currency risk premia.

Purpose of the Study:

  • To construct a sovereign default network using high-dimensional vector autoregressions.
  • To analyze the impact of network centrality measures on currency risk premia.
  • To develop and evaluate a novel trading strategy based on network insights.

Main Methods:

  • Employed high-dimensional vector autoregressions to analyze CDS market connectedness.
  • Developed four network centrality measures: degree, betweenness, closeness, and eigenvector.
  • Assessed the relationship between network centralities and currency excess returns and forward spreads.

Main Results:

  • Closeness and betweenness centralities negatively drive currency excess returns.
  • Network centralities are independent of unconditional carry trade risk factors.
  • A trading strategy (long peripheral, short core currencies) yielded a higher Sharpe ratio than currency momentum.

Conclusions:

  • Network properties in CDS markets significantly influence currency risk premia.
  • The developed network-based trading strategy offers superior performance and robustness.
  • Findings provide valuable insights for investors and policymakers in global financial markets.