Does Business Cycle Risk Account for Systematic Returns from Currency Positioning? The International Perspective

Abstract

Low-yielding currencies (relative to dollar interest rate and based on annual data) represent a strong hedging tool for a US investor in the event of a slowdown of the US economy, as shown in Lustig and Verdelhan (2007). In this paper we show that such a conclusion is far more general, holding jointly for representative agents in a number of countries (Australia, Canada, France, United Kingdom and United States) and for quarterly holding period returns, which are closer to the frequency at which portfolios are re-balanced. The prices of risk for nondurable and durable consumption growth explain the cross-sectional variation of average currency portfolio returns, as confirmed by high Rý coefficients. However, statistical significance of the coefficients, checked both individually and joint, does not exceed 10%. Overall, taking an economic standpoint, holding currencies that pay out low interest rates provides some means of insurance against economic slowdown in the domestic economy.

Keywords: Asset Pricing, Consumption Risk, UIP

JEL Classification: E21, E43, F31, G11, G12