Common Risk Factors in Currency Markets

Abstract

We build portfolios of monthly currency forward contracts sorted on forward discounts. The spread between returns on the lowest and highest interest rate currency portfolios is more than 5 percentage points per annum between 1983 and 2007 after taking into account bid-ask spreads. The annualized Sharpe ratio on a carry trade strategy that goes long in the highest and short in the lowest interest rate currency basket is 0.6. We provide new evidence for a systematic risk explanation of these currency excess returns. We show that a single common risk factor accounts for their cross-sectional variation. We find that these excess returns are highly predictable over time and that expected excess returns are strongly counter-cyclical, supporting the view that currency excess returns are compensation for bearing macroeconomic risk. We show that a simple affine framework reproduces both cross-sectional and predictability results.