The Share of Systematic Risk in Exchange Rates

Abstract

Changes in exchange rates are not random. Two factors account for 20% to 90% of the monthly exchange rate movements in developed countries. These two factors - a dollar and a carry factor - also explain a large share of daily and quarterly changes in exchange rates. Similar results emerge for developing countries with floating currencies. Moreover, the factor structure is persistent. As a result, if these two factors were known one period in advance, mean squared errors would be a fraction of those obtained assuming that exchange rates are random walks. Across countries, the higher the share of systematic equity risk, the higher the share of systematic currency risk. These results have direct implications for asset managers, motivate further work on exchange rates, and offer new insights into international economics and finance models.