Common Risk Factors in Currency Markets

63 Pages Posted: 14 Jul 2008 Last revised: 25 Jun 2010

See all articles by Hanno N. Lustig

Hanno N. Lustig

Stanford Graduate School of Business; National Bureau of Economic Research (NBER)

Nikolai L. Roussanov

University of Pennsylvania - The Wharton School; National Bureau of Economic Research (NBER)

Adrien Verdelhan

Massachusetts Institute of Technology (MIT) - Sloan School of Management; National Bureau of Economic Research (NBER)

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Date Written: June 2008

Abstract

We identify a 'slope' factor in exchange rates. High interest rate currencies load more on this slope factor than low interest rate currencies. As a result, this factor can account for most of the cross-sectional variation in average excess returns between high and low interest rate currencies. A standard, no-arbitrage model of interest rates with two factors - a country- specific factor and a global factor - can replicate these findings, provided there is sufficient heterogeneity in exposure to the global risk factor. We show that our slope factor is a global risk factor. By investing in high interest rate currencies and borrowing in low interest rate currencies, US investors load up on global risk, particularly during bad times.

Suggested Citation

Lustig, Hanno N. and Roussanov, Nikolai L. and Verdelhan, Adrien, Common Risk Factors in Currency Markets (June 2008). NBER Working Paper No. w14082, Available at SSRN: https://ssrn.com/abstract=1159046

Hanno N. Lustig (Contact Author)

Stanford Graduate School of Business ( email )

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Nikolai L. Roussanov

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Adrien Verdelhan

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