The Share of Systematic Variation in Bilateral Exchange Rates

Abstract

Two factors account for 20% to 90% of the daily, monthly, quarterly, and annual exchange rate movements. These two factors -carry and dollar -are risk factors: the former accounts for the cross-section of interest rate-sorted currency returns, while the latter accounts for a novel cross-section of dollar beta-sorted currency returns. The different shares of systematic risk across currencies are related to financial and macroeconomic measures of international comovement. They point to large shares of global shocks in the dynamics of exchange rates, as well as large differences across countries. The results offer new challenges for international macroeconomics and finance models.

On financial risk and the safe haven characteristics of Swiss franc exchange rates

“…This framework features one Swiss franc-specific and one global risk factor. 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. However, it is the sensitivity to global risk that reveals the safe haven characteristic of a currency.…”

“…One potential explanation for the lack of empirical support for UIP is the presence of a risk premium required by market participants for a foreign currency investment (e.g. Verdelhan, 2006, 2007;Ranaldo and Söderlind, 2010;Verdelhan, 2010Verdelhan, , 2012Farhi and Garbaix, 2011;Lustig et al, 2011;Menkhoff et al, 2012;Sarno et al, 2012;Bansal and Shaliastovich, 2013). According to this literature, covariation of exchange rate returns with contemporaneous currency risk factors is responsible for the ex post deviation from the UIP condition.…”

“…Pricing models of exchange rate returns: recent empirical advances According to this asset pricing view on exchange rate determination, UIP regressions, such as Eq. (5), should be augmented by incorporating currency risk factors (Verdelhan, 2012). Such regressions could then take the following form…”

“…A steadily growing literature argues that (ex post) deviations from the uncovered interest rate parity (UIP) condition can be rationalized by the covariation of exchange rate changes with risk factors (e.g. Lustig and Verdelhan, 2006and Verdelhan, , 2007Ranaldo and Söderlind, 2010;Verdelhan, 2010Verdelhan, , 2012Farhi and Garbaix, 2011;Lustig et al, 2011;Menkhoff et al, 2012;Sarno et al, 2012;Bansal and Shaliastovich, 2013). Safe haven characteristics imply a close link to financial risk factors.…”

“…It is hence natural to analyse Swiss franc exchange rate changes in this framework. We adopt the asset pricing framework of Verdelhan (2012), based on Backus et al (2001) and Lustig et al (2011), to analyse 11 bilateral Swiss franc exchange rate pairs during the time period from January 1990 to August 2011. This framework features one Swiss franc-specific and one global risk factor.…”