Country Fundamentals and Currency Excess Returns

Abstract

(ProQuest: ... denotes formulae omitted.)I. IntroductionThe purpose of this paper is to show that country fundamentals matter for the cross-section of currency excess returns. We include the variables reflecting macroeconomic fundamentals, such as interest rate, default risk, and foreign exchange rate regime. We also include the variables reflecting the degree of capital control and the size of capital market. We speculate that variations of country fundamentals may significantly affect the currency returns through increasing or decreasing the currency risks. For example, the adoption of more flexible exchange rate regime may increase the currency risks substantially. Our analysis shows that these variables do have explanatory power for the cross-section of currency excess returns.Some previous works also considered the country fundamentals as important determinants of currency returns. For example, Jorda and Taylor (2012) and Coudert and Mignon (2013) emphasize the relation of the real exchange rate and default risk with the currency returns, respectively. However, we consider a more extensive set of country fundamentals in this paper and adopt an empirical method basically different from the previous studies.This paper's empirical methodology is partly motivated both by Lustig et al. (2011), and Lustig and Verdelhan (2007). They explain the cross-section of currency returns with a single factor-the global carry profits in case of Lustig et al. (2011) and the global consumption growth in case of Lustig and Verdelhan (2007).We adopt the factor model framework of these authors, but we include new factors that are based on country fundamentals.1In a series of their highly original papers, Pojarliev and Levich (2008, 2010, 2011) build a multi-factor currency returns model from the popular currency strategies such as carry, value, trend following, and volatility. Pojarliev and Levich used the factor model to explain the performance of currency fund managers. We modify the work of Pojarliev and Levich in two directions. First, we construct factors from country fundamentals rather than from investment-style returns. Second, we use the factor model to explain the performance of currencies, rather than currency fund managers.Our main empirical results are based on monthly currency excess returns of 19 major currencies for the 10-year period between January 2001 and December 2010. The 19 currencies have been selected after dropping those currencies with inadequate fundamental data. Our main findings can be summarized as follows:First, when the currencies are sorted on the basis of forward premium, exchange rate regime, the degree of capital control, and the size of capital markets, there are persistent return differences between high-ranked and low-ranked currencies. When the currencies are sorted by default risk, the return differences between high-ranked and low-ranked currencies are not persistent. As far as forward premium is concerned, the pattern has been discussed extensively in the previous literature. The results regarding the other fundamental variables are original in this paper.Second, a parsimonious model with three factors-forward premium, default risk, and foreign exchange rate regime-explains a large part of the cross-section of currency excess returns.Also the zero-intercept restriction of the factor model is not rejected for 13 out of 19 currencies. In comparison, a factor model with three investment-style factors is rejected for 14 out of 19 currencies.In recent years, the persistent profits of so-called carry trades have drawn many authors' attention.2 Carry traders buy a high-yield currency and sell a low-yield currency, or, equivalently, take a long forward position in a high-yield currency against a low-yield currency. Such trades exploit the failure of the uncovered interest parity (UIP). If the UIP holds, the excess returns cannot be predicted by interest rate or forward premium. …