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

60 Pages Posted: 11 Sep 2017

See all articles by Hanno N. Lustig

Hanno N. Lustig

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

Robert Richmond

New York University (NYU) - Department of Finance

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Date Written: September 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.

Suggested Citation

Lustig, Hanno N. and Richmond, Robert, Gravity in FX R-Squared: Understanding the Factor Structure in Exchange Rates (September 2017). NBER Working Paper No. w23773. Available at SSRN: https://ssrn.com/abstract=3035126

Hanno N. Lustig (Contact Author)

Stanford Graduate School of Business ( email )

Stanford GSB
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Stanford, CA California 94305-6072
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National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
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Robert Richmond

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

Stern School of Business
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New York, NY 10012-1126
United States

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