Working Paper: NBER ID: w28260
Authors: Mikhail Chernov; Magnus Dahlquist; Lars A. 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 pricing; stochastic discount factor; excess returns; currency market; risk pricing
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 |
|---|---|
| Conditional projection of the stochastic discount factor (SDF) (G19) | Pricing of the full cross-section of currencies (F31) |
| Unconditional mean-variance efficient portfolio (UMVE) (G19) | Time series variation in strategy returns (C22) |
| Main factors driving the covariance matrix of returns (C10) | Significant sources of risk for the marginal currency investor (F31) |
| Optimal timing (C41) | Construction of the UMVE (Y20) |
| Conditional expected returns vary significantly across strategies (G11) | Construction of the UMVE (Y20) |