52 Pages Posted: 8 Aug 2012
Date Written: February 2005
Aggregate consumption growth risk explains why low interest rate currencies do not appreciate as much as the interest rate differential and why high interest rate currencies do not depreciate as much as the interest rate differential. We sort foreign T-bills into portfolios based on the nominal interest rate differential with the US, and we test the Euler equation of a US investor who invests in these currency portfolios. US investors earn negative excess returns on low interest rate currency portfolios and positive excess returns on high interest rates currency portfolios. We find that low interest rate currencies provide US investors with a hedge against US aggregate consumption growth risk, because these currencies appreciate on average when US consumption growth is low, while high interest rate currencies depreciate when US consumption growth is low. As a result, the risk premia predicted by the Consumption-CAPM match the average excess returns on these currency portfolios.
Suggested Citation: Suggested Citation
Lustig, Hanno N. and Verdelhan, Adrien, The Cross-Section of Currency Risk Premia and Us Consumption Growth Risk (February 2005). NBER Working Paper No. w11104. Available at SSRN: https://ssrn.com/abstract=663486
By Karen Lewis