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Common Risk Factors in Currency Markets

Listed author(s):
  • Nick Roussanov

    (Wharton)

  • Adrien Verdelhan

    (Boston University)

  • Hanno Lustig

    (UCLA)

We build portfolios of monthly currency forward contracts sorted on forward discounts. The spread between returns on the lowest and highest interest rate currency portfolios is more than 5 percentage points per annum between 1983 and 2007 after taking into account bid-ask spreads. The annualized Sharpe ratio on a carry trade strategy that goes long in the highest and short in the lowest interest rate currency basket is 0.6. We provide new evidence for a systematic risk explanation of these currency excess returns. We show that a single common risk factor accounts for their cross-sectional variation. We find that these excess returns are highly predictable over time and that expected excess returns are strongly counter-cyclical, supporting the view that currency excess returns are compensation for bearing macroeconomic risk. We show that a simple affine framework reproduces both cross-sectional and predictability results.

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File URL: https://economicdynamics.org/meetpapers/2008/paper_711.pdf
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Paper provided by Society for Economic Dynamics in its series 2008 Meeting Papers with number 711.

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Date of creation: 2008
Handle: RePEc:red:sed008:711
Contact details of provider: Postal:
Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA

Web page: http://www.EconomicDynamics.org/society.htm
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