Common Risk Factors in Currency Markets
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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Copy CitationHanno Lustig, Nikolai Roussanov, and Adrien Verdelhan, "Common Risk Factors in Currency Markets," NBER Working Paper 14082 (2008), https://doi.org/10.3386/w14082.
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Published Versions
Hanno Lustig & Nikolai Roussanov & Adrien Verdelhan, 2011. "Common Risk Factors in Currency Markets," Review of Financial Studies, vol 24(11), pages 3731-3777.