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, Revised in December 2011
NBER Program(s):Asset Pricing, International Finance and Macroeconomics

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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Document Object Identifier (DOI): 10.3386/w14082

Published: Hanno Lustig & Nikolai Roussanov & Adrien Verdelhan, 2011. "Common Risk Factors in Currency Markets," Review of Financial Studies, vol 24(11), pages 3731-3777.

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