A 'Bad Beta, Good Beta' Anatomy of Currency Risk Premiums and Trading Strategies
92 Pages Posted: 15 Jun 2019
Date Written: May 23, 2019
We test a two-beta currency pricing model that features betas with risk-premium news and real-rate news of the currency market. Unconditionally, beta with currency market risk-premium news is “bad” because of significantly positive price of risk (2.52% per year); beta with global real-rate news is “good” due to nearly zero or negative price of risk. The price of risk-premium beta risk is counter-cyclical, while the price of the real-rate beta risk is pro-cyclical. Most prevailing currency trading strategies either have excessive “bad beta” or too little “good beta,” failing to deliver abnormal performance. Our empirical results can be delivered by a no-arbitrage model with precautionary savings and a pricing kernel characterized by two separate global shocks.
Keywords: currency risk premium, real exchange rate, variance decomposition, present value decomposition, multifactor model, carry trade
JEL Classification: F31, G12, G15
Suggested Citation: Suggested Citation