Macro-Based Factors for the Cross-Section of Currency Returns

39 Pages Posted: 13 May 2023 Last revised: 7 Jun 2023

See all articles by Leland Bybee

Leland Bybee

Yale School of Management

Leandro Gomes

Yale School of Management

Joao Paulo Valente

Yale University, Department of Economics, Students

Date Written: February 26, 2022

Abstract

We use macroeconomic characteristics and exposures to Carry and Dollar as instruments to estimate a latent factor model with time-varying betas with the instrumented principal components analysis (IPCA) method by Kelly et al. (2020). On a pure out-of-sample basis, this model can explain up to 78% of cross-sectional variation of a Global panel of currencies excess returns, compared to only 27.9% for Dollar and Carry and 51% for a static PCA model. The latent factor and time-varying exposures are directly linked to macroeconomic fundamentals. The most relevant are exports exposures to commodities and US trade, credit over GDP, and interest rate differentials. This model, therefore, sheds light on how to incorporate macroeconomic fundamentals to explain time-series and cross-section.

Keywords: currency risk, factor models

JEL Classification: G12, G15, F31

Suggested Citation

Bybee, Leland and Gomes, Leandro and Valente, Joao Paulo, Macro-Based Factors for the Cross-Section of Currency Returns (February 26, 2022). Available at SSRN: https://ssrn.com/abstract=4400205 or http://dx.doi.org/10.2139/ssrn.4400205

Leland Bybee (Contact Author)

Yale School of Management ( email )

135 Prospect Street
P.O. Box 208200
New Haven, CT 06520-8200
United States

Leandro Gomes

Yale School of Management

Joao Paulo Valente

Yale University, Department of Economics, Students ( email )

28 Hillhouse Ave
New Haven, CT 06520-8268
United States

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