Corruption, Carry Trades, and the Cross Section of Currency Returns

Abstract

This is the first paper to explore the effects of perceived corruption on the FX market. It finds that the currencies of countries perceived to suffer from high levels of corruption generate statistically significantly lower returns than the currencies of countries perceived to have low levels of corruption. Moreover, the portfolio spread is highly correlated with NBER recessions and U.S. consumption growth of nondurable goods. Interestingly, stochastic discount factor model analysis reveals that the portfolio spread is useful for pricing the cross section of currency returns, even when controlling for standard FX risk factors.

Keywords: Corruption, corruption perceptions, corruption risk, FX markets, currency markets

JEL Classification: G12, G14