Pricing Currency Risks

Abstract

The currency market features a small cross-section, and conditional expected returns can be characterized by few signals: interest differential, trend, and mean reversion. We exploit these properties to construct the ex ante mean-variance efficient portfolio of individual currencies. The portfolio is updated in real time and prices all prominent currency trading strategies, conditionally and unconditionally. The fraction of risk in these assets that does not affect their risk premiums is at least 85%. Extant explanations of carry strategies based on intermediary capital or global volatility are related to these unpriced components, while consumption growth is related to the priced component of returns.

Currency Risk Premiums Redux?

“…The closest paper to ours is independent work by Chernov, Dahlquist, and Lochstoer (2023), which tackles similar objectives to the ones targeted in our paper, in a very different way. Specifically, Chernov, Dahlquist, and Lochstoer (2023) address the question of the optimal factor model for pricing currency risk, which relates to the first goal of our paper. They do so by directly studying the mean-variance efficient portfolio and relying on the conditional projection of the SDF onto excess returns of individual currencies.…”

“…On the one hand, this approach has the advantage, relative to the methods adopted in our paper, that currency pricing is carried out more directly since the estimated SDF is represented as a linear function of the unconditional mean-variance efficient portfolio. On the other hand, working directly with the mean-variance efficient portfolio can only be achieved on a set of assets that is small enough to allow reliable estimation of the covariance matrix of currency returns, which is the case in the paper by Chernov, Dahlquist, and Lochstoer (2023). Moreover, one has to take a stand on the set of factors or signals that drive the conditional mean.…”

“…In turn, this exposes the approach to potential omitted-variable problems (in addition to potential measurement-error problems), which are instead taken into account using the GX three-pass methods employed in our paper. Ultimately, we view the study of Chernov, Dahlquist, and Lochstoer (2023) as complementary to our paper.…”