Working Paper: CEPR ID: DP15571
Authors: Mikhail Chernov; Magnus Dahlquist; Lars Lochstoer
Abstract: The currency market features a relatively small cross-section and conditional expected returns can be characterized by only a few signals – interest differentials, trend and mean-reversion. We exploit these properties to construct a conditional projection of the stochastic discount factor onto excess returns of individual currencies. Our approach is implementable in real time and prices all currencies and prominent strategies conditionally as well as unconditionally. We document that the fraction of unpriced risk in these assets is at least 85%. Extant explanations of carry strategies based on intermediary capital or global volatility are related to these unpriced components, while consumption growth is related to the priced component of returns.
Keywords: currency risk premiums; stochastic discount factor; factor models
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 |
|---|---|
| stochastic discount factor (SDF) (D15) | currency returns (F31) |
| unconditional mean-variance efficient portfolio (UMVE) (D81) | strategy returns (L21) |
| stochastic discount factor (SDF) (D15) | consumption growth (E20) |
| stochastic discount factor (SDF) (D15) | equity returns (G12) |
| interest differentials (E43) | conditional price of risk (G19) |
| optimal timing in strategy construction (C41) | performance (D29) |