Common Risk Factors in Currency Markets

By Hanno Lustig, Nikolai L. Roussanov, A. Verdelhan. 2011

943 citations recorded by the source corpus.

We identify a "slope" factor in exchange rates. High interest rate currencies load more on this slope factor than low interest rate currencies. This factor accounts for most of the cross-sectional variation in average excess returns between high and low interest rate currencies. A standard, no-arbitrage model of interest rates with two factors--a country-specific factor and a global factor--can replicate these findings, provided there is sufficient heterogeneity in exposure to global or common innovations. We show that our slope factor identifies these common shocks, and we provide empirical evidence that it is related to changes in global equity market volatility. By investing in high interest rate currencies and borrowing in low interest rate currencies, U.S. investors load up on global risk. The Author 2011. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oup.com., Oxford University Press.

Subfields: Economics and Econometrics, Finance

View Paper: https://www.semanticscholar.org/paper/a3b00538feeca36b82a87d5d488808010a711728

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Citations in the corpus

On financial risk and the safe haven characteristics of Swiss franc exchange rates (2015, methodology): “Consistent with Lustig et al. (2011) and Verdelhan (2012) we find that exposure to the Swissfranc -specific risk factor explains most of the time variation in Swiss franc returns.”
An Anatomy of Commodity Futures Risk Premia (2014, neutral): “Papers like Fama and French (1993, 1996), Cochrane and Piazzessi (2005, 2008), and Lustig, Roussanov, and Verdelhan (2011), among others, find that the cross-section of stocks, bonds, and currency returns, respectively, can be explained by relatively few factors.”
Volatility Risk Premia and Exchange Rate Predictability (2016, positive): “Lustig, Roussanov, and Verdelhan (2011) study these currency portfolio returns using their first two principal components.”
Risk and Return Spillovers Among the G10 Currencies (2016, background): “As mentioned above, the countercyclical currency risk premia described by Lustig et al. (2014) are likely to result in stronger interactions between returns and innovations in RNV and RNS in bad times over the business cycle as returns become more sensitive to changes in risk and vice versa.”
Commodity Trade and the Carry Trade: a Tale of Two Countries (2017, methodology): “In a pioneering study, Lustig and Verdelhan (2007) show that carry trade risk premia line up with loadings on the U.S. aggregate consumption growth; Lustig, Roussanov, and Verdelhan (2011) and Menkhoff, Sarno, Schmeling, and Schrimpf (2012) link these risk premia to covariances with the global…”
Properties of Foreign Exchange Risk Premiums (2012, background): “The findings of Lustig and Verdelhan (2007) suggest that expected excess returns should be negatively related to signed consumption (26)We also use the TED spread (difference between the 3-month Eurodollar rate and the 3-month Treasury rate) as an alternative proxy.”
Currency Momentum Strategies (2012, positive): “…to standard proxies for business cycle risk, liquidity risk (Brunnermeier, Nagel, and Pedersen, 2009), the carry trade risk factor proposed by Lustig, Roussanov, and Verdelhan (2011), volatility risk (Menkhoff, Sarno, Schmeling, and Schrimpf, 2011), the three Fama-French factors (Fama and…”
A Theory of Foreign Exchange Interventions (2020, positive): “Table 1: Do increases in reserves coincide with positive wedges in the uncovered interest parity condition (UIP)? Quarterly reserve flows are taken from the IMF’s Balance of Payments statistics, merged with quarterly UIP wedges and interest rate spreads computed based on data from Lustig et al. (201”
Variance Risk Premiums and the Forward Premium Puzzle (2012, positive): “…exposures to the common factor is acknowledged in Gourio, Siemer, and Verdelhan (2012); Farhi, Fraiberger, Gabaix, Ranciere, and Verdelhan (2009); Backus, Foresi, and Telmer (2001) and Lustig, Roussanov, and Verdelhan (2011); and in a no-arbitrage setting in Lustig, Roussanov, and Verdelhan (2012).”