The Trade Imbalance Network and Currency Returns

Abstract

We extend the theory of Gabaix and Maggiori (2015) 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 Centrality Based 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