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Common Risk Factors in Currency Markets

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  • Hanno Lustig
  • Nikolai Roussanov
  • Adrien Verdelhan

Abstract

We identify a 'slope' factor in exchange rates. High interest rate currencies load more on this slope factor than low interest rate currencies. As a result, this factor can account for most of the cross-sectional variation in average excess returns between high and low interest rate currencies. A standard, no-arbitrage model of interest rates with two factors - a country- specific factor and a global factor - can replicate these findings, provided there is sufficient heterogeneity in exposure to the global risk factor. We show that our slope factor is a global risk factor. By investing in high interest rate currencies and borrowing in low interest rate currencies, US investors load up on global risk, particularly during bad times.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 14082.

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Date of creation: Jun 2008
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Publication status: published as Rev. Financ. Stud. (2011) doi: 10.1093/rfs/hhr068 First published online: August 30, 2011
Handle: RePEc:nbr:nberwo:14082

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