Dynamic Interactions between Government Bonds and Exchange Rate Expectations in Currency Options

This paper examines the dynamic interactions between the government bond yields of Germany, Japan and the US and their exchange rate expectations anticipated in the currency options, i.e., risk reversals (put premia) of the US dollar versus the yen and euro. Short-term, one-way information flow from the government bond market to the currency option market was substantial before the introduction of quantitative easing by the US Fed in response to the 2008 global financial crisis; this pattern diminished after the 2013 taper tantrum. The long-term bond yields are important and separable determinants of the risk reversals. The negative relationship between the spreads of the US Treasury yield over the other two countries’ bond yields, and the dollar risk reversals indicating a fall in US dollar interest rate, implies dollar depreciation expectations embedded in currency option prices, not an appreciation, as predicted by uncovered interest rate parity.