A 'Bad Beta, Good Beta' Anatomy of Currency Risk Premiums and Trading Strategies
115 Pages Posted: 15 Jun 2019 Last revised: 16 Jun 2023
Date Written: June 16, 2023
Abstract
The paper introduces a novel two-beta currency pricing model to address the "flat dollar beta vs. premium" puzzle by decomposing the conventional dollar factor beta into a beta with risk-premium news and a beta with real-interest-rate news. These betas capture distinct features of currency returns and explain cross-sectional variations in currency risk premiums. The risk-premium beta is
associated with an unconditionally positive price of risk, while the real-rate beta has an unconditionally negative price of risk due to precautionary savings. The prices of these beta risks exhibit conditional variations tied to economic conditions. Furthermore, the model explains the abnormal performance of various currency trading strategies.
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