The Cross-Section of Currency Appreciation Rates

Abstract

We compute a cross-sectional variance decomposition for the average appreciation rate of foreign currencies. The cross-sectional dispersion in average nominal exchange rate growth is due to predictability of interest rate spreads among non-G10 currencies. However, among G10 currencies, we have an opposite pattern with cross-sectional return predictability playing the dominant role. The importance of the return channel among the G10 currencies is even stronger for real appreciation rates. By decomposing the cross-sectional return channel, pricing errors outweigh currency risk premia in terms of explaining nominal currency appreciation among G10 currencies. These results suggest important differences between G10 and other currencies.

Keywords: exchange rates, currency returns, currency risk premia, interest rate differentials, variance decomposition, carry trade, linear factor models, currency factors

JEL Classification: F31, G12, G15