Pricing Implications of Covariances and Spreads in Currency Markets

Abstract

We introduce a covariance and spread (i.e., exchange rate forward discount) adjusted carry factor that prices the cross-section of FX market returns, where many other single and multi-factor models fail. Both the covariance matrix of exchange rate growths and forward discounts contain important information for pricing, which is not captured by well-known factors. The conditional covariance matrix and forward discounts are time-varying and forecast future realized currency returns.

Keywords: Foreign Exchange, Carry, Forward Discount, Spread Adjustment, Covariance Adjustment, Mean-Variance, Factor Pricing Model, Predictability

JEL Classification: F31, F37, G12, G15, G17