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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. Matteo Maggiori, 2013. "The U.S. Dollar Safety Premium," 2013 Meeting Papers 75, Society for Economic Dynamics.
  2. Christopher J. Neely & Paul A. Weller, 2011. "Technical analysis in the foreign exchange market," Working Papers 2011-001, Federal Reserve Bank of St. Louis.
  3. Charlotte Christiansen & Maik Schmeling & Andreas Schrimpf, 2010. "A Comprehensive Look at Financial Volatility Prediction by Economic Variables," CREATES Research Papers 2010-58, School of Economics and Management, University of Aarhus.
  4. Sarno, Lucio & Schneider, Paul & Wagner, Christian, 2012. "Properties of foreign exchange risk premiums," Journal of Financial Economics, Elsevier, vol. 105(2), pages 279-310.
  5. Karen K. Lewis, 2011. "Global asset pricing," Globalization and Monetary Policy Institute Working Paper 88, Federal Reserve Bank of Dallas.
  6. 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.).
  7. Ralph S.J. Koijen & Stijn Van Nieuwerburgh, 2010. "Predictability of Returns and Cash Flows," NBER Working Papers 16648, National Bureau of Economic Research, Inc.
  8. Arash, Aloosh, 2011. "Variance Risk Premium Differentials and Foreign Exchange Returns," MPRA Paper 40829, University Library of Munich, Germany, revised 18 Aug 2012.
  9. 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.
  10. 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.
  11. John H. Cochrane, 2011. "Discount Rates," NBER Working Papers 16972, National Bureau of Economic Research, Inc.
  12. 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.
  13. Andreas Stathopoulos & Andrea Vedolin & Philippe Mueller, 2012. "International Correlation Risk," 2012 Meeting Papers 818, Society for Economic Dynamics.
  14. Matteo Maggiori, 2012. "Financial Intermediation, International Risk Sharing, and Reserve Currencies," 2012 Meeting Papers 146, Society for Economic Dynamics.
  15. 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.
  16. 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.
  17. Jeremy Graveline & Irina Zviadadze & Mikhail Chernov, 2012. "Crash Risk in Currency Returns," 2012 Meeting Papers 753, Society for Economic Dynamics.
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