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; National Bureau of Economic Research (NBER)
Massachusetts Institute of Technology (MIT) - Sloan School of Management; National Bureau of Economic Research (NBER)
May 3, 2011
Review of Financial Studies ( 2011), 24(11)
We identify a ‘slope’ factor in exchange rates. High interest rate currencies load more on this slope factor than low interest rate currencies. This factor accounts 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 global or common innovations. We show that our slope factor identifies these common shocks, and we provide empirical evidence that it is related to changes in global equity market volatility. By investing in high interest rate currencies and borrowing in low interest rate currencies, US investors load up on global risk.
Number of Pages in PDF File: 74
Keywords: Carry Trade, Currency Risk
JEL Classification: G12, G15, F31
Date posted: June 1, 2008 ; Last revised: August 27, 2012
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