Geopolitical risk and currency returns

Abstract

This study investigates the relationship between geopolitical risk (GPR) and currency excess returns. A zero-cost strategy that buys higher GPR currencies and sells lower GPR currencies generates a significant excess return of 5.72% per year. These returns contain information that goes beyond traditional currency investment strategies and cannot be explained by existing risk factors in asset pricing tests. Furthermore, the GPR factor is positively priced in broad cross sections of currency portfolios and in individual currencies. Further investigation reveals that the observed return predictability of GPR for currency returns stems from the country-specific idiosyncratic risk component and the regional risk component.