Trade Imbalance Network and Currency Risk Premia

Abstract

This paper proposes a new risk factor based on a multi-country’s trading imbalance network to explain foreign exchange rate fluctuations and currency risk premia associated with a currency carry trade strategy. We build a directed in-degree trading network of global countries linked by their pair wise trading deficit using import and export trading data collected from UN comtrade. After sorting currencies portfolios based on the centrality scores, the new risk factor, i.e., CMP, Central Minus Peripheral is created by buying central countries currency and shorting peripheral countries currency. We then use this factor to explain the risk premium of the foreign currency and currency excess returns cross sectional variations. Our results confirm the explanatory power of the new risk factor. We show that the new measure has signifcant explanatory power to currency risk premium and corsssectional foreign currency excess returns after controlling the existing risk factors of e.g., Lustig and Verdelhan (2011), Corte et al. (2016), and Richmond (2019).