The Share of Systematic Variation in Bilateral Exchange Rates

Sorting countries by their dollar currency betas produces a novel cross section of average currency excess returns. A slope factor (long in high beta currencies and short in low beta currencies) accounts for this cross section of currency risk premia. This slope factor is orthogonal to the high-minu...

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Bibliographic Details
Published in:The Journal of finance (New York) 2018-02, Vol.73 (1), p.375-418
Main Author: VERDELHAN, ADRIEN
Format: Article
Language:English
Subjects:
Beta
Currency
Economic models
Foreign exchange rates
Interest rates
Markets
Money
Portfolios
Risk factors
Risk premiums
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Summary:Sorting countries by their dollar currency betas produces a novel cross section of average currency excess returns. A slope factor (long in high beta currencies and short in low beta currencies) accounts for this cross section of currency risk premia. This slope factor is orthogonal to the high-minus-low carry trade factor built from portfolios of countries sorted by their interest rates. The two high-minus-low risk factors account for 18% to 80% of the monthly exchange rate movements. The two risk factors suggest that stochastic discount factors in complete markets' models should feature at least two global shocks to describe exchange rates.
ISSN:0022-1082
1540-6261
DOI:10.1111/jofi.12587