The Share of Systematic Variation in Bilateral Exchange Rates
54 Pages Posted: 19 Sep 2011 Last revised: 30 Oct 2015
Date Written: July 1, 2015
Sorting countries by their dollar currency betas produces a novel cross-section of average currency excess returns. A slope factor (long in high beta currencies and short in low beta currencies) accounts for this cross-section of currency risk premia. This slope factor is orthogonal to the high-minus-low carry trade factor built from portfolios of countries sorted by their interest rates. The two high-minus-low risk factors account for 18% to 80% of the monthly exchange rate movements. The two risk factors suggest that stochastic discount factors in complete markets' models should feature at least two global shocks to describe exchange rates.
Keywords: exchange rates, forward premium puzzle, risk premium
JEL Classification: F31
Suggested Citation: Suggested Citation