Currency Premia and Global Imbalances

Abstract

Global imbalances are a fundamental economic determinant of currency risk premia. We propose a factor that captures exposure to countries' external imbalances -termed the global imbalance risk factor -and show that it explains most of the cross-sectional variation in currency excess returns. The economic intuition of this factor is simple: net foreign debtor countries offer a currency risk premium to compensate investors willing to finance negative external imbalances. Investment currencies load positively on the global imbalance factor while funding currencies load negatively, implying that carry trade investors are compensated for taking on global imbalance risk.

The Share of Systematic Variation in Bilateral Exchange Rates

“…In the logic of that model, global shocks emerge from the wealth dynamics of financial intermediaries. DellaCorte, Sarno, and Riddiough (2014) present related evidence on the levels of net foreign asset positions and interest rates. Tables I and II.…”

The Share of Systematic Variation in Bilateral Exchange Rates

“…In the logic of that model, global shocks emerge from the wealth dynamics of financial intermediaries. DellaCorte, Sarno, and Riddiough () present related evidence on the levels of net foreign asset positions and interest rates.…”

US Equity Tail Risk and Currency Risk Premia

“…This paper also contributes to a second branch of the literature on explaining the excess return of currency carry trade and momentum. Several studies show that different variables can explain the excess return of the carry trade returns; for example, US consumption risk in Lustig and Verdelhan (2007), innovations to FX volatility in Menkhoff, Sarno, Schmeling, and Schrimpf (2012a), US equity downside risk in Lettau, Maggiori, and Weber (2014) and Dobrynskaya (2014), global long-run consumption news in Colacito, Croce, Gavazzoni, and Ready (2018), and global imbalances in Della Corte, Riddiough, and Sarno (2016). Filippou, Gozluklu, and Taylor (2018) show that the winner portfolio in the currency momentum strategy is compensated for the exposure to the global political risk of those currencies.…”