The Cross-Section of Currency Risk Premia and US Consumption Growth Risk
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.
Published: Hanno Lustig & Adrien Verdelhan, 2007. "The Cross Section of Foreign Currency Risk Premia and Consumption Growth Risk," American Economic Review, American Economic Association, vol. 97(1), pages 89-117, March.
This paper was revised on September 7, 2006