Pricing Risks Across Currency Denominations

Abstract

We document a novel empirical regularity that investors in low interest rate countries earn substantially higher Sharpe ratios on identical carry trade strategies than investors in high interest rate countries. We further document that bilateral exchange rate volatilities are increasing in interest rate differentials between currencies. These observations place new important restrictions on no-arbitrage models of international asset pricing. Our analysis naturally gives rise to a new non-parametric procedure to estimate country-specific stochastic discount factors (SDFs) from exchange rate data. In support of our approach, out-of-sample, the estimated SDFs sort linearly with national output gap fluctuations, and price risks in international equity markets.