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Gravity in FX R-Squared: Understanding the Factor Structure in Exchange Rates

66 Pages Posted: 30 Oct 2015 Last revised: 10 Oct 2017

Hanno N. Lustig

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

Robert J. Richmond

New York University (NYU) - Department of Finance

Multiple version iconThere are 2 versions of this paper

Date Written: October 1, 2017

Abstract

We relate the risk characteristics of currencies to measures of physical, cultural, and institutional distance. The currencies of countries which are more distant from other countries are more exposed to systematic currency risk. This is due to a gravity effect in the factor structure of bilateral exchange rates: When a currency appreciates against a basket of all other currencies, its bilateral exchange rate appreciates more against the currencies of distant countries. As a result, currencies of peripheral countries are more exposed to the systematic variation than currencies of central countries. Trade network centrality is the best predictor of a currency's average exposure to systematic risk.

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 R-Squared: Understanding the Factor Structure in Exchange Rates (October 1, 2017). 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 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 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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