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Countercyclical currency risk premia

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  • Lustig, Hanno
  • Roussanov, Nikolai
  • Verdelhan, Adrien

Abstract

We describe a novel currency investment strategy, the ‘dollar carry trade,’ which delivers large excess returns, uncorrelated with the returns on well-known carry trade strategies. Using a no-arbitrage model of exchange rates we show that these excess returns compensate U.S. investors for taking on aggregate risk by shorting the dollar in bad times, when the U.S. price of risk is high. The countercyclical variation in risk premia leads to strong return predictability: the average forward discount and U.S. industrial production growth rates forecast up to 25% of the dollar return variation at the one-year horizon. The estimated model implies that the variation in the exposure of U.S. investors to worldwide risk is the key driver of predictability.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Financial Economics.

Volume (Year): 111 (2014)
Issue (Month): 3 ()
Pages: 527-553

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Handle: RePEc:eee:jfinec:v:111:y:2014:i:3:p:527-553

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Web page: http://www.elsevier.com/locate/inca/505576

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Keywords: Exchange rates; Forecasting; Risk;

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References

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Citations

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Cited by:
  1. Charlotte Christiansen & Maik Schmeling & Andreas Schrimpf, 2012. "A Comprehensive Look at Financial Volatility Prediction by Economic Variables," BIS Working Papers 374, Bank for International Settlements.
  2. Andreas Stathopoulos & Andrea Vedolin & Philippe Mueller, 2012. "International Correlation Risk," 2012 Meeting Papers 818, Society for Economic Dynamics.
  3. Jeremy Graveline & Irina Zviadadze & Mikhail Chernov, 2012. "Crash Risk in Currency Returns," 2012 Meeting Papers 753, Society for Economic Dynamics.
  4. Arash, Aloosh, 2011. "Variance Risk Premium Differentials and Foreign Exchange Returns," MPRA Paper 40829, University Library of Munich, Germany, revised 18 Aug 2012.
  5. Ralph S.J. Koijen & Stijn Van Nieuwerburgh, 2011. "Predictability of Returns and Cash Flows," Annual Review of Financial Economics, Annual Reviews, vol. 3(1), pages 467-491, December.
  6. Lucio Sarno & Paul Schneider & Christian Wagner, 2012. "Properties of Foreign Exchange Risk Premiums," Working Paper Series 10_12, The Rimini Centre for Economic Analysis.
  7. Matteo Maggiori, 2012. "Financial Intermediation, International Risk Sharing, and Reserve Currencies," 2012 Meeting Papers 146, Society for Economic Dynamics.
  8. Silvia Miranda Agrippino & Hélène Rey, 2013. "Funding Flows and Credit in Carry Trade Economies," RBA Annual Conference Volume, in: Alexandra Heath & Matthew Lilley & Mark Manning (ed.), Liquidity and Funding Markets Reserve Bank of Australia.
  9. Michael D. Bauer & Glenn D. Rudebusch & Jing (Cynthia) Wu, 2011. "Unbiased estimate of dynamic term structure models," Working Paper Series 2011-12, Federal Reserve Bank of San Francisco.
  10. Christopher J. Neely & Paul A. Weller, 2011. "Technical analysis in the foreign exchange market," Working Papers 2011-001, Federal Reserve Bank of St. Louis.
  11. John H. Cochrane, 2011. "Discount Rates," NBER Working Papers 16972, National Bureau of Economic Research, Inc.
  12. Juan M. Londono & Hao Zhou, 2012. "Variance risk premiums and the forward premium puzzle," International Finance Discussion Papers 1068, Board of Governors of the Federal Reserve System (U.S.).
  13. Matteo Maggiori, 2013. "The U.S. Dollar Safety Premium," 2013 Meeting Papers 75, Society for Economic Dynamics.
  14. Karen K. Lewis, 2011. "Global asset pricing," Globalization and Monetary Policy Institute Working Paper 88, Federal Reserve Bank of Dallas.
  15. Gregory H. Bauer & Antonio Diez de los Rios, 2012. "An International Dynamic Term Structure Model with Economic Restrictions and Unspanned Risks," Working Papers 12-5, Bank of Canada.
  16. Doukas, John A. & Zhang, Hao, 2013. "The performance of NDF carry trades," Journal of International Money and Finance, Elsevier, vol. 36(C), pages 172-190.
  17. Michael D. Bauer & Glenn D. Rudebusch & Jing Cynthia Wu, 2014. "Term Premia and Inflation Uncertainty: Empirical Evidence from an International Panel Dataset: Comment," American Economic Review, American Economic Association, vol. 104(1), pages 323-37, January.
  18. Wouter Hueskes & Ralph S.J. Koijen & Evert B. Vrugt & Jules H. van Binsbergen, 2011. "A Term Structure of Growth," 2011 Meeting Papers 672, Society for Economic Dynamics.

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