Common Risk Factors in Currency Markets

Abstract

W e identify a “slope” factor in exchange rates. High interest rate currencies load more on this slope factor than low interest rate currencies. This factor accounts for most of the crosssectional 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 global or common innovations. We show that our slope factor identifies these common shocks, and we provide empirical evidence that it is related to changes in global equity market volatility. By investing in high interest rate currencies and borrowing in low interest rate currencies, U.S. investors load up on global risk. ( JEL G12, G15, F31) W e show that the large co-movement among exchange rates of different currencies supports a risk-based view of exchange rate determination. In order to do so, we start by identifying a slope factor in exchange rate changes: The exchange rates of high interest rate currencies load positively on this factor, while those of low interest rate currencies load negatively on it. The covariation with this slope factor accounts for most of the spread in average returns between baskets of high and low interest rate currencies—the returns on the currency carry trade. We show that a no-arbitrage model of interest rates and exchange rates with two state variables—country-specific and global risk factors—can match the data, provided there is sufficient heterogeneity in countries’ exposures to the global risk factor. To support this global risk interpretation, we provide evidence that the global risk factor is closely related to changes in volatility of equity markets around the world. We identify this common risk factor in the data by building monthly portfolios of currencies sorted by their forward discounts. The first portfolio contains