Working Paper: NBER ID: w11104
Authors: Hanno Lustig; Adrien Verdelhan
Abstract: 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.
Keywords: Currency risk premia; Consumption growth; Euler equation
JEL Codes: G00; F30
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| low interest rate currencies (F31) | appreciation (D46) |
| US consumption growth is low (F62) | appreciation (D46) |
| high interest rate currencies (F31) | depreciation (D25) |
| US consumption growth is low (F62) | depreciation (D25) |
| consumption growth beta of a currency (F31) | relationship between currency risk premia and US consumption growth risk (F31) |
| average excess returns on currency portfolios (F31) | predicted risk premia from consumption CAPM (D11) |