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Common Risk Factors in Currency Markets

Review of Financial Studies ( 2011), 24(11)

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74 Pages Posted: 1 Jun 2008 Last revised: 27 Aug 2012

Hanno N. Lustig

Stanford Graduate School of Business; National Bureau of Economic Research (NBER)

Nikolai L. Roussanov

University of Pennsylvania - The Wharton School; National Bureau of Economic Research (NBER)

Adrien Verdelhan

Massachusetts Institute of Technology (MIT) - Sloan School of Management; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: May 3, 2011

Abstract

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.

Keywords: Carry Trade, Currency Risk

JEL Classification: G12, G15, F31

Suggested Citation

Lustig, Hanno N. and Roussanov, Nikolai L. and Verdelhan, Adrien, Common Risk Factors in Currency Markets (May 3, 2011). Review of Financial Studies ( 2011), 24(11); .. Available at SSRN: https://ssrn.com/abstract=1139447 or http://dx.doi.org/10.2139/ssrn.1139447

Hanno N. Lustig (Contact Author)

Stanford Graduate School of Business ( email )

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National Bureau of Economic Research (NBER)

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Nikolai L. Roussanov

University of Pennsylvania - The Wharton School ( email )

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National Bureau of Economic Research (NBER)

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Adrien Verdelhan

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

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Cambridge, MA 02142
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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