Currency Risk Premia Research Articles

Nominal exchange rates and heterogeneous beliefs

We propose a two-country model with heterogeneous beliefs to understand dynamics of nominal exchange rate. Facing a shock to monetary policy, disagreement between domestic and foreign investors shifts the relative wealth of investors – an essential part of the stochastic discount factor in our model – which then moves the foreign exchange rate. Calibrated to U.S. and U.K. data, our model reveals that dispersion in beliefs predicts the future spot exchange rate, associates with the cross-section of currency risk premia, and comoves with the time-varying volatility in currency returns. Furthermore, our model suggests that domestic investors would hold fewer foreign currency-denominated bonds in countries with greater disagreements on monetary policy.

UNCERTAINTY, LONG‐RUN, AND MONETARY POLICY RISKS IN A TWO‐COUNTRY MACRO MODEL

AbstractWe study the currency risk premium and the forward premium bias in a two‐country New Keynesian model with production, no physical capital, and recursive utility. Monetary policy follows an interest rate feedback rule and exogenous total factor productivity (TFP) growth follows a long‐run risk process with stochastic volatility, which we estimate from data. With cross‐country heterogeneity in TFP and monetary policy, reasonable currency risk premia emerge under complete and incomplete markets but the forward premium bias is trivial. We diagnose the challenge faced by this fairly standard production model to explain the forward premium bias.

Uncovered interest rate, overshooting, and predictability reversal puzzles in an emerging economy

By using realized and survey-based expected exchange rate data, the paper presents five key findings regarding the Uncovered Interest rate Parity (UIP) and related puzzles in an Emerging Market (EM). First, Fama regressions, when not accounting for shifts in the UIP relationship, yield slopes that are statistically identical to one, irrespective of whether survey-based expected exchange rates or realized exchange rates are used. Second, caution is necessary however, as our analysis identifies three distinct sub-periods within each exchange rate measure, each exhibiting varying levels of puzzling behavior. Third, under realized exchange rates, expectation errors can introduce both downward and upward biases or no bias at all, depending on the sub-period. On the other hand, currency risk premiums consistently lead to a downward bias. Under expected exchange rates, currency risk premiums continue to exert a downward bias at varying degrees across sub-periods. Fourth, responses to interest rate differential shocks by expectation errors are pivotal in inducing both downward and upward biases or removing biases altogether when utilizing realized exchange rate data. Fifth, evidence concerning overshooting and reversal puzzles, as well as their link to the UIP puzzle, varies depending on the specific sub-period and the choice of exchange rate measurement, making it more intricate than the previous literature has documented.

A credit-based theory of the currency risk premium

This paper uncovers a novel component for exchange rate predictability based on the price difference between sovereign credit default swaps denominated in different currencies. This new forecasting variable – the credit-implied risk premium – captures the expected currency depreciation conditional on a severe but rare credit event. Using data for 16 Eurozone countries, we find that the credit-implied risk premium positively forecasts the dollar-euro exchange rate return at various horizons. Moreover, a currency strategy that exploits the informative content of our predictor generates substantial out-of-sample economic value against the naïve random walk benchmark.

Sovereign default network and currency risk premia

We construct a sovereign default network by employing high-dimensional vector autoregressions obtained by analyzing connectedness in sovereign credit default swap markets. We develop four measures of centrality, namely, degree, betweenness, closeness, and eigenvector centralities, to detect whether network properties drive the currency risk premia. We observe that closeness and betweenness centralities can negatively drive currency excess returns but do not exhibit a relationship with forward spread. Thus, our developed network centralities are independent of an unconditional carry trade risk factor. Based on our findings, we develop a trading strategy by taking a long position on peripheral countries’ currencies and a short position on core countries’ currencies. The aforementioned strategy generates a higher Sharpe ratio than the currency momentum strategy. Our proposed strategy is robust to foreign exchange regimes and the coronavirus disease 2019 pandemic.

The risk premium in times of financial crisis: an assessment from ICAPM on the MENA region

The purpose of our research is to study the impact of financial crisis on Risk premium evolution for a set of emerging countries of MENA (Middle East and North Africa), giving special attention to the appreciation of the local risk premium in addition to the currency risk premium through the study of the dynamics of the financial integration under two assumptions: perfect integration and partial segmentation. At the methodological level, we test a conditional version of the international model of the financial assets ICAPM of De initially proposed by Adler and Dumas 1983 [Adler, M., & Dumas, B. (1983). International portfolio choice and corporation finance: A synthesis. The Journal of Finance, 38(3), 925-984.]. Our analysis is based on the conditional model of regime change of Bekaert and Harvey (1995) [Bekaert, G., & Harvey, C. R. (1995). Time‐varying world market integration. The Journal of Finance, 50(2), 403-444.], we follow the econometric modeling using the Kalman filter and the Markov regime-switching model with variable transition probabilities.

International Yield Curves and Currency Puzzles

ABSTRACTThe currency depreciation rate is often computed as the ratio of foreign to domestic pricing kernels. Using bond prices alone to estimate these kernels leads to currency puzzles: the inability of models to match violations of uncovered interest parity and the volatility of exchange rates. This happens because of the FX bond disconnect, the inability of bonds to span exchange rates. Incorporating innovations to the pricing kernel that affect exchange rates but not bonds helps resolve the puzzles. This approach also allows one to relate news about cross‐country differences between international yields to news about currency risk premiums.

User cost of foreign monetary assets under dollarization

We use a Capital Asset Price Model (CAPM) model to derive the formula of user cost for foreign monetary asset whose rates of return are subject to foreign exchange risk premia. Our formula shows that only domestic non-monetary asset can be used as the benchmark asset. In fact, under dollarization the local currency’ assets offer a higher risk premium and return over the dollar denominated one because the latter is preferred over the first for hedging motives. Using data from Chile (from June 2003 to January 2022) and Croatia (from December 2011 to March 2022), our results show that the inclusion of the currency risk premium has improved substantially the formula proposed by Barnett (1978).

Fiscal Regimes and the Exchange Rate

In this paper, we argue that the effect of monetary and fiscal policies on the exchange rate depends on the fiscal regime. A contractionary monetary (expansionary fiscal) shock can lead to a depreciation, rather than an appreciation, of the domestic currency if debt is not backed by future fiscal surpluses. We look at daily movements of the Brazilian real around policy announcements and find strong support for the existence of two regimes with opposite signs. The unconventional response of the exchange rate occurs when fiscal fundamentals are deteriorating and markets' concern about debt sustainability is rising. To rationalize these findings, we propose a model of sovereign default in which foreign investors are subject to higher haircuts and fiscal policy shifts between Ricardian and non-Ricardian regimes. In the latter, sovereign default risk drives the currency risk premium and affects how the exchange rate reacts to policy shocks.

Cross-border valuation using the International CAPM and the constant perpetual growth model

For cross-border valuation to be consistent with the International CAPM (ICAPM), translating projected cash flows across currencies should account for a currency risk premium and the economic interaction between uncertain cash flows and uncertain exchange rates. The conventional translation method ignores these items. This study proposes a translation method that is consistent with the ICAPM, given the constant perpetual growth model of valuation. Using empirical data, the study illustrates the conventional translation method’s potentially substantial valuation error if the ICAPM describes the risk-return trade-off in financial markets.

Exchange Rates and Sovereign Risk

An increase in a country’s sovereign risk, as measured by credit default swap spreads, is accompanied by a contemporaneous depreciation of its currency and an increase of its volatility. The relation between currency excess returns and sovereign risk is mainly driven by default expectations (rather than distress risk premia) and exposure to global sovereign risk shocks and also emerges in a predictive setting for currency risk premia. We show that a sovereign risk factor is priced in the cross-section of currency returns and that it is not subsumed by the carry factor. This paper was accepted by David Simchi-Levi, finance.

GDP Linked Bonds and Currency Risk Premiums

GDP Linked Bonds and Currency Risk Premiums

The missing risk premium in exchange rates

We use a present-value model of the real exchange rate to impose structure on the currency risk premium. We allow the currency risk premium to depend on both the interest rate differential and a latent component: the missing risk premium. Consistent with the data, our present-value model implies that the real exchange rate should predict currency returns. We find that the missing risk premium, not the interest rate differential, explains most of the variation in the real exchange rate. Moreover, our model sheds light on puzzling relations between the interest rate differential, the real exchange rate, and the currency risk premium.

Entangled risks in incomplete FX markets

We introduce the concept of risk entanglement in a preference-free setting to jointly explain the exchange rate volatility, cyclicality, and currency risk premia in the data. Risk entanglement specifies a subset of incomplete market models, in which nondiffusive or nonlog-normal shocks to exchange rates are not fully spanned by asset returns. When risks are entangled, there exist multiple pricing-consistent exchange rates, but none of them are equal to the ratio of the stochastic discount factors (SDFs) or their projections. Decoupling the exchange rate from the SDFs allows us to address key FX market patterns that are puzzling in international finance.

Central bank tone and currency risk premia

I analyze how the tone of central bank press conferences impacts risk premia in the currency market. Tone is measured as the difference between the number of hawkish and dovish phrases mafide during a press conference, as a fraction of total phrases. A one standard deviation increase in the hawkishness of a press conference is associated with a 1.5% decline in the variance risk premium, a 4.9% decline in the subsequent variance swap return, and a 0.2% increase in option implied risk aversion. The impact of tone comes primarily from the questions & answers, or the unscripted portion of the press conference.

Fiscal Cyclicality and Currency Risk Premia

Abstract I develop a model of real exchange rate determination that attributes a central role to the intertemporal government budget condition, which equates the market value of government debt to the present value of government surpluses. To enforce this equilibrium condition in the presence of nominal rigidities, the real exchange rate has to adjust in response to shocks to government surpluses. The model predicts that fiscal shocks account for real exchange rate movements, and the factor structure in fiscal shocks aligns with the factor structure in currency returns. Both predictions are confirmed in the sample of developed countries.

Equity tail risk and currency risk premiums

We find that an option-based equity tail risk factor is priced in the cross section of currency returns; more exposed currencies offer a low risk premium because they hedge against equity tail risk. A portfolio that buys currencies with high equity tail beta and shorts those with low beta extracts the global component in the tail factor. The estimated price of risk of this novel global factor is consistently negative in currency carry and momentum portfolios, and in portfolios of other asset classes, suggesting that excess returns of these strategies can be partially understood as compensations for global tail risk.

Monetary policy’s rising FX impact in the era of ultra-low rates

We show that the impact of monetary policy on exchange rates has been growing significantly in recent years. Our results are established by a high-frequency event study of how key fixed income instruments with different maturities respond jointly with exchange rates to monetary policy news from six major central banks. Across countries, news affecting short-term maturity bonds tend to have the strongest impact, highlighting the relevance of communication regarding the path of future monetary policy for exchange rate movements even when policy rates are near their lower bound. We find that the FX impact of monetary policy is state-dependent and is stronger the lower is the level of interest rates, in line with a greater effect through currency risk premia.

Currency Risk Premia Redux

We study a large currency cross section using recently developed asset pricing methods. First, we show that the implied pricing kernel includes three latent factors: a strong U.S. `Dollar' level factor, and two weak, high Sharpe ratio `Carry' and `Momentum' slope factors. The evidence for an additional 'Value' factor is scant. Second, based on this pricing kernel, we obtain robust estimates of the risk premia of more than 100 non-tradable risk factors. Some of these factors - mostly relating to volatility, uncertainty and liquidity conditions in currency and other markets - are priced, disclosing a clear nexus across asset classes.

Currency Risk and Capital Accumulation

The Lucas Paradox states that there are large and persistent differences in capital-output ratios across countries, suggesting capital is not flowing to countries where it is relatively scarce. In the data, capital-output ratios vary a lot cross-sectionally even within developed countries, and they are negatively correlated with currency risk premia and risk-free rates. To rationalize these patterns, I build a quantitative multi-country model of capital accumulation with external habit and heterogeneous exposures to a global productivity shock. I show that currency risk in this model generates cross-country variations in risk-free rates and capital-output ratios that are consistent with the data. I estimate the model using GDP data from countries issuing the G10 currencies and find two main results: (1) The heterogenous loadings that I extract from GDP data alone are highly correlated with capital-output ratios; and (2) when I feed the estimated loadings to the model, model-generated capital-output ratios account for roughly 55% of the cross-country variation in the data. I conclude that variation in currency risk and therefore currency risk premia have significant effects on the real economy.