Gravity in FX Rsquared: Understanding the Factor Structure in Exchange Rates

41 Pages Posted: 30 Oct 2015  

Hanno N. Lustig

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

Robert J. Richmond

New York University (NYU) - Department of Finance

Date Written: October 26, 2015

Abstract

Exchange rates strongly co-vary against their base currency. We uncover a gravity equation in this factor structure: the key determinant of a country’s exchange rate beta on the common base factor is the country’s distance from the base country. The farther the country, the larger the beta. For example, the beta of the CHF/USD exchange rate on the dollar factor is determined by the distance between Switzerland and the United States. Shared language, legal origin, shared border, resource similarity and colonial linkages also significantly lower the betas. On average, the exchange rates of peripheral countries tend to have high Rsquareds in factor regressions, while central countries have low Rsquareds. A no-arbitrage model of exchange rates replicates this distance-dependent factor structure when the exposure of pricing kernels to global risk factors is more similar for closer country pairs.

Keywords: Exchange Rates, Factor Models, Gravity Equation, Home Bias.

JEL Classification: F31, G12

Suggested Citation

Lustig, Hanno N. and Richmond, Robert J., Gravity in FX Rsquared: Understanding the Factor Structure in Exchange Rates (October 26, 2015). Stanford University Graduate School of Business Research Paper No. 15-54. Available at SSRN: https://ssrn.com/abstract=2680298 or http://dx.doi.org/10.2139/ssrn.2680298

Hanno N. Lustig

Stanford Graduate School of Business ( email )

Stanford GSB
655 Knight Way
Stanford, CA California 94305-6072
United States
3108716532 (Phone)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Robert J. Richmond (Contact Author)

New York University (NYU) - Department of Finance ( email )

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

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