Working Paper: NBER ID: w14082
Authors: Hanno Lustig; Nikolai Roussanov; Adrien Verdelhan
Abstract: We identify a 'slope' factor in exchange rates. High interest rate currencies load more on this slope factor than low interest rate currencies. As a result, this factor can account for most of the cross-sectional variation in average excess returns between high and low interest rate currencies. A standard, no-arbitrage model of interest rates with two factors - a country- specific factor and a global factor - can replicate these findings, provided there is sufficient heterogeneity in exposure to the global risk factor. We show that our slope factor is a global risk factor. By investing in high interest rate currencies and borrowing in low interest rate currencies, US investors load up on global risk, particularly during bad times.
Keywords: currency risk; excess returns; interest rates; global risk factors
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 |
|---|---|
| global risk price (G19) | currency risk premia (F31) |
| low interest rate currencies (F31) | global risk exposure (F65) |
| average interest rate difference (E43) | currency risk premia (F31) |
| carry trade risk factor (F31) | excess returns (D46) |
| currency excess returns (F31) | predictability (D84) |
| average excess returns on low interest rate currencies (F31) | average excess returns on high interest rate currencies (F31) |