Systematic Consumption Risk in Currency Returns
81 Pages Posted: 4 Jul 2013
Date Written: June 1, 2013
We sort currencies into portfolios by countries’ consumption growth over the past year. The excess return of the highest-consumption-growth currency portfolio over the portfolio of lowest-consumption-growth currencies is positive on average, compensating investors for large negative returns during world-wide downturns. This return – our consumption carry factor – prices the cross-section of portfolio-sorted and of bilateral currency returns. Our results rest on minimal theoretical restrictions but can be interpreted in a habit formation model: sorting currencies on past consumption growth approximates sorting countries based on risk aversion and low (high) risk-aversion currencies depreciate (appreciate) in times of global turmoil.
Keywords: Foreign exchange, uncovered interest parity, carry trade returns, consumption risk, asset pricing, habit model
JEL Classification: E44, F31, F44, G12, G15
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