The Trade Imbalance Network and Currency Returns

57 Pages Posted: 9 Aug 2023 Last revised: 25 Oct 2023

See all articles by Ai Jun Hou

Ai Jun Hou

Stockholm University

Lucio Sarno

University of Cambridge - Judge Business School; Centre for Economic Policy Research (CEPR)

Xiaoxia Ye

University of Exeter Business School - Department of Finance

Date Written: October 23, 2023

Abstract

We extend the theory of Gabaix and Maggiori (2015a, 2015b) to study currency risk premia in a multi-country world with imperfect financial markets. Currency returns are connected to financiers’ limited commitment, captured by the complexity of their balance sheets in the trade imbalance network. Guided by the theory, we construct a characteristic, CBC, based on the centrality of the imbalance network and variance-covariance of currency returns. Sorting currencies on CBC generates a high Sharpe ratio, and the resulting excess returns cannot be explained by standard currency factors and intermediary asset pricing factors, suggesting a novel source of currency predictability.

Keywords: Trade imbalance network, Currency premia, Carry trade, Network centrality

JEL Classification: F31, F37, G12, G15

Suggested Citation

Hou, Ai Jun and Sarno, Lucio and Ye, Xiaoxia, The Trade Imbalance Network and Currency Returns (October 23, 2023). Available at SSRN: https://ssrn.com/abstract=4534287 or http://dx.doi.org/10.2139/ssrn.4534287

Ai Jun Hou

Stockholm University ( email )

Universitetsvägen 10
Stockholm, Stockholm SE-106 91
Sweden

Lucio Sarno

University of Cambridge - Judge Business School ( email )

Trumpington Street
Cambridge, CB2 1AG
United Kingdom

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Xiaoxia Ye (Contact Author)

University of Exeter Business School - Department of Finance ( email )

Streatham Court
Exeter, EX4 4PU
United Kingdom

HOME PAGE: http://www.xiaoxiaye.me/

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