Abstract
We investigate if unemployment fluctuations generate predictability in the cross-section of currency excess returns. We find that currencies with lower growth in the unemployment rate appreciate, while currencies with higher growth in the unemployment rate depreciate. As a result, the investment strategy that invests in the former and shorts the latter produces positive and sizable excess returns. This strategy improves the performance of the optimal portfolio of the currency investor. Asset pricing tests show that the predictability is not a compensation for traditional risk-factors, such as global equity risk, global foreign exchange volatility and downside risk, but instead relates to currency value and momentum. In addition, we find support for an explanation concerning limits to arbitrage in the foreign exchange rate market.
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