Exchange Rates, Carry Trade Returns and Political Risks

Abstract

This paper elucidates the channels through which sovereign risk, exchange rates and currency risk premia are related. I show that the channels are different depending on whether a country is classified as emerging or an advanced economy. Generally, for emerging market economies, local sovereign risk factors, namely country-specific political risk and macroeconomic risk do play a significant role in the depreciation of the local currency relative to the U.S. dollar. Whilst there is no convincing evidence that local determinants of sovereign risk cause a depreciation of currencies of advanced economies before the 2007 financial crisis, I do find that political risk does matter for advanced economies in the post-crisis era. For both sets of economies, global factors also play an important role in the relationship between sovereign risk and exchange rates. Secondly, double-sorting 34 currencies into different portfolios based on the level of macro risk and political risk, I provide evidence that local determinants of sovereign risk are priced in the FX markets, i.e. they can forecast currency carry trade excess returns in the cross-section. Local political risk in particular seems to have become an important carry trade risk factor in the post-2007 financial crisis era. This is the first research to explain carry trade excess returns with local sovereign risk factors as against sovereign risk as a whole.