A 'Bad Beta, Good Beta' Anatomy of Currency Risk Premiums and Trading Strategies
95 Pages Posted: 15 Jun 2019 Last revised: 18 May 2020
Date Written: May 15, 2020
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 a significantly positive price of risk of 2.52% per year; beta with global real-rate news is "good" because of the negative price of risk. The price of risk-premium-beta risk is countercyclical, whereas the price of the real-rate-beta risk is procyclical. Most prevailing currency trading strategies have either excessive "bad beta" or too little "good beta," thus fail 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