58 Pages Posted: 18 Mar 2010 Last revised: 14 Jan 2012
Date Written: January 13, 2012
We describe a novel currency investment strategy, the ‘dollar carry trade,’ which delivers large excess returns, uncorrelated with the returns on well-known carry trade strategies. Using a no-arbitrage model of exchange rates we show that these excess returns compensate U.S. investors for taking on aggregate risk by shorting the dollar in bad times, when the price of risk is high. The counter-cyclical variation in risk premia leads to strong return predictability: the average forward discount and U.S. industrial production growth rates forecast up to 25% of the dollar return variation at the one-year horizon.
Keywords: Exchange Rates, Forecasting, Risk Premia
JEL Classification: G12, G15, F31
Suggested Citation: Suggested Citation
Lustig, Hanno N. and Roussanov, Nikolai L. and Verdelhan, Adrien, Countercyclical Currency Risk Premia (January 13, 2012). AFA 2011 Denver Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1571714 or http://dx.doi.org/10.2139/ssrn.1571714