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The Cross-Section of Currency Risk Premia and US Consumption Growth Risk

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  • Hanno Lustig
  • Adrien Verdelhan

Abstract

Aggregate consumption growth risk explains why low interest rate currencies do not appreciate as much as the interest rate differential and why high interest rate currencies do not depreciate as much as the interest rate differential. We sort foreign T-bills into portfolios based on the nominal interest rate differential with the US, and we test the Euler equation of a US investor who invests in these currency portfolios. US investors earn negative excess returns on low interest rate currency portfolios and positive excess returns on high interest rates currency portfolios. We find that low interest rate currencies provide US investors with a hedge against US aggregate consumption growth risk, because these currencies appreciate on average when US consumption growth is low, while high interest rate currencies depreciate when US consumption growth is low. As a result, the risk premia predicted by the Consumption-CAPM match the average excess returns on these currency portfolios.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 11104.

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Date of creation: Feb 2005
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Publication status: published as Hanno Lustig & Adrien Verdelhan, 2007. "The Cross Section of Foreign Currency Risk Premia and Consumption Growth Risk," American Economic Review, American Economic Association, vol. 97(1), pages 89-117, March.
Handle: RePEc:nbr:nberwo:11104

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Cited by:
  1. CASTRO, Rui & CLEMENTI, Gian Luca, 2009. "The Economic Effects of Improving Investor Rights in Portugal," Cahiers de recherche, Universite de Montreal, Departement de sciences economiques 2009-07, Universite de Montreal, Departement de sciences economiques.
  2. Fernando Alvarez & Andrew Atkeson & Patrick J. Kehoe, 2009. "Time-Varying Risk, Interest Rates, and Exchange Rates in General Equilibrium," Review of Economic Studies, Oxford University Press, vol. 76(3), pages 851-878.
  3. Sarno, Lucio & Schneider, Paul & Wagner, Christian, 2011. "Properties of Foreign Exchange Risk Premiums," CEPR Discussion Papers, C.E.P.R. Discussion Papers 8503, C.E.P.R. Discussion Papers.
  4. Frankel, Jeffrey & Poonawala, Jumana, 2010. "The forward market in emerging currencies: Less biased than in major currencies," Journal of International Money and Finance, Elsevier, Elsevier, vol. 29(3), pages 585-598, April.
  5. Wagner, Christian, 2012. "Risk-premia, carry-trade dynamics, and economic value of currency speculation," Journal of International Money and Finance, Elsevier, Elsevier, vol. 31(5), pages 1195-1219.
  6. Sarno, Lucio & Schneider, Paul & Wagner, Christian, 2010. "Properties of Foreign Exchange Risk Premia," MPRA Paper 21302, University Library of Munich, Germany.

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