Working Paper: CEPR ID: DP14015
Authors: Lucio Sarno; Ric Colacito; Steven Riddiough
Abstract: We find a strong link between currency excess returns and the relative strength of the business cycle. Buying currencies of strong economies and selling currencies of weak economies generates high returns both in the cross section and time series of countries. These returnsstem primarily from spot exchange rate predictability, are uncorrelated with common currency investment strategies, and cannot be understood using traditional currency risk factors in either unconditional or conditional asset pricing tests. We also show that a business cycle factor implied by our results is priced in a broad currency cross section.
Keywords: exchange rates; currency risk premium; business cycles; long-run risk
JEL Codes: F31; G12; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| business cycles (E32) | currency excess returns (F31) |
| strong economies (P17) | currency excess returns (F31) |
| output gaps (E23) | currency excess returns (F31) |
| business cycles (E32) | spot exchange rate predictability (F31) |
| currency portfolios sorted by output gaps (F31) | excess returns (D46) |