Currency Premia and Global Imbalances

Abstract

We show that a global imbalance risk factor that captures the spread in countries'external imbalances and their propensity to issue external liabilities in foreign currency explains the cross-sectional variation in currency excess returns. The economic intuition is simple: net debtor countries o¤er a currency risk premium to compensate investors willing to …nance negative external imbalances because their currencies depreciate in bad times. This mechanism is consistent with exchange rate theory based on capital ‡ows in imperfect …nancial markets. We also …nd that the global imbalance factor is priced in cross sections of other major asset markets.

International Liquidity and Exchange Rate Dynamics

“…This modeling formalizes a number of external crises where broadly defined global risk aversion shocks, embodied here in Γ, caused large depreciations of the currencies of countries that had recently experienced large capital inflows. Della Corte, Riddiough and Sarno (2013) offer empirical evidence consistent with our theoretical predictions. They show that netdebtor countries' currencies have higher returns that net-creditors' currencies and that net debtor countries' currencies tend to be on the receiving end of carry trade related speculative flows.…”

“…Intuitively, a debtor country has borrowed from world financial markets and therefore its currency has to depreciate on impact and be expected to appreciate, thus generating a positive currency excess return, to compensate the financiers for holding the currency risk. Della Corte, Riddiough and Sarno (2013) offer empirical evidence consistent with our theoretical predictions. They show that net debtor countries' currencies have higher returns that net creditors' currencies and that net debtor countries' currencies tend to be on the receiving end of carry trade related speculative flows.…”

Currency Risk Factors in a Recursive Multicountry Economy

“…A GROWING EMPIRICAL LITERATURE IN international finance examines the structure of risk in the cross section of currency returns (see, among others, Lustig and Verdelhan (2007), Lustig, Roussanov, and Verdelhan (2014), Della Corte, Riddiough, and Sarno (2016)). These studies sort currencies on various criteria and highlight the empirical relevance of several economic and financial factors.…”

“…In addition, we document that, in our model, sorting countries on interest rates is equivalent to sorting on net foreign asset (NFA) positions and exposure to long-run global growth news. This suggests that the factors proposed by Della Corte, Riddiough, and Sarno (2016) and Lustig, Roussanov, and Verdelhan (2011) may be the risk-sharing outcome of a single fundamental source of heterogeneity, namely, their different exposure to global long-run growth news.…”

From carry trades to curvy trades

“…Building currency portfolios based on prospective exchange rate movements yields return distributions which are less skewed and thus less subject to tail risks. In this way, we also add to the related literature that rationalises the salient feature of negative return skewness with the stronger sensitivity of high interest rate currencies to FX volatility, and, to a lesser extent, liquidity constraints and commodity prices (Bakshi & Panayotov, 2013;Della Corte, Riddiough, & Sarno, 2016;Lustig, Roussanov, & Verdelhan, 2011;Lustig, Stathopoulos, & Verdelhan, 2013;Menkhoff, Sarno, Schmeling, & Schrimpf, 2012). With the return distribution being broadly symmetric, excess returns of curvy trade portfolios cannot be explained by observable risk factors-an assessment that is confirmed in a linear asset pricing framework.…”