Currency Premia and Global Imbalances
73 Pages Posted: 18 Apr 2016
Date Written: February 2016
We show that a global imbalance risk factor that captures the spread in countries' external imbalances and their propensity to issue external liabilities in foreign currency explains the cross-sectional variation in currency excess returns. The economic intuition is simple: net debtor countries offer a currency risk premium to compensate investors willing to finance negative external imbalances because their currencies depreciate in bad times. This mechanism is consistent with exchange rate theory based on capital flows in imperfect financial markets. We also find that the global imbalance factor is priced in cross sections of other major asset markets.
Keywords: carry trade, currency risk premium, foreign exchange excess returns, global imbalances
JEL Classification: F31, F37, G12, G15
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