The information content of risk reversals in emerging market currencies

Abstract

This paper analyzes the information content of risk reversals for ten emerging market currencies. In contrast to the findings for major developed currencies, it is found that in some cases risk reversals (RR) are helpful in predicting currency returns, but in general RR are predicted by but do not predict carry trade returns. Evidence based on country vector autoregressions (VARs) and a panel VAR (PVAR) indicate that RR react in a procyclicalway to carry returns, i.e., it is cheaper (more expensive) to buy protection against currency weakness after positive (negative) total returns. All in all, it is found that crash risk accounts for a small share of carry trade returns variance, which seems to be more related to global risk aversion shocks. A sentiment indicator of crash risk in emerging market currencies is highly correlated with the VIX.