The Trade Imbalance Network and Currency Returns
57 Pages Posted: 9 Aug 2023 Last revised: 25 Oct 2023
Date Written: October 23, 2023
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: Suggested Citation