Essays in Empirical Dynamic Asset Pricing : Methods and Applications in Foreign Exchange
The thesis consists of three independently readable essays dealing with the estimation of dynamic linear factor pricing models and the dynamic factor structure of currency return cross-sections. The first essay introduces a likelihood-based approach to estimate linear factor models with time-varying risk premia, where risk exposures (betas) and risk prices (lambdas) are updated in each period, such that the one-step ahead prediction error is reduced given the current observation. For illustration purposes, among others, an empirical application of the novel method to the factor structure of currency carry trades is conducted. The second essay develops this idea further and provides an empirical study of time-varying risk premia in style-based currency investing strategies that employs methodological results from the first chapter. It shows that risk premia dynamics in the three currency trading strategies carry, momentum and value are heterogeneous and supports the view that they compensate for different sources of risk. Essay 3 investigates an economic interpretation of the currency cross-section that the second essay analyzes technically from a dynamic perspective. It empirically supports an intermediation-based model for currency cross-sections, in which the financial conditions of the biggest three foreign exchange (FX) dealers by market share serves as a risk factor.