NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Common Risk Factors in Currency Markets

Hanno Lustig, Nikolai Roussanov, Adrien Verdelhan

NBER Working Paper No. 14082
Issued in June 2008
NBER Program(s):   AP   IFM

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.

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A data appendix is available at http://www.nber.org/data-appendix/w14082

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Document Object Identifier (DOI): 10.3386/w14082

Published: Rev. Financ. Stud. (2011) doi: 10.1093/rfs/hhr068 First published online: August 30, 2011

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