The Cross Section of Foreign Currency Risk Premia and Consumption Growth Risk
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What they found
The authors sorted currencies into portfolios by their interest rate and studied the returns to a U.S. investor from 1953 to 2002. High-interest-rate currency portfolios earned substantially higher returns than low-interest ones, and these returns lined up with exposure to U.S. consumption growth risk: high-interest currencies depreciate when U.S. consumption growth is low, that is, in bad times. This was the first paper to treat currency carry returns as a cross-sectional asset-pricing problem and argue they are compensation for systematic risk.
What you can use
- Carry returns are systematic: portfolios of high-yield currencies beat low-yield ones consistently over five decades.
- The premium exists because high-yield currencies crash in bad economic times, exactly when investors can least afford losses.
- Sorting currencies into portfolios diversifies away much of the noise of any single carry pair.
Caveats
Consumption-based explanation has been contested (Burnside and coauthors). Long sample with changing exchange-rate regimes. Technical.
Tags: forex, carry, risk-premium, asset-pricing
Summaries are our own reading of the paper, not the authors' words. Educational only, not advice. Discuss it in Book Club.