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Common Risk Factors in Currency Markets
Hanno N. Lustig UCLA, Anderson School of Management; National Bureau of Economic Research (NBER) Nikolai L. Roussanov University of Pennsylvania - The Wharton School Adrien Verdelhan Boston University - Department of Economics; National Bureau of Economic Research (NBER); Banque de France - Economic Study and Research Division April 2009 Paris December 2008 Finance International Meeting AFFI - EUROFIDAI 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.
Keywords: Carry Trade, Currency Risk JEL Classifications: G12, G15, F31 Working Paper SeriesDate posted: June 01, 2008 ; Last revised: May 05, 2009Suggested CitationContact Information
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