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Title: Pricing Currency Risks

Author(s): Mikhail Chernov, Magnus Dahlquist and Lars Lochstoer

Publication Date: December 2020

Keyword(s): currency risk premiums, factor models and Stochastic discount factor

Programme Area(s): Financial Economics and International Macroeconomics and Finance

Abstract: The currency market features a relatively small cross-section and conditional expected returns can be characterized by only a few signals â?? interest differentials, trend and mean-reversion. We exploit these properties to construct a conditional projection of the stochastic discount factor onto excess returns of individual currencies. Our approach is implementable in real time and prices all currencies and prominent strategies conditionally as well as unconditionally. We document that the fraction of unpriced risk in these assets 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.

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Bibliographic Reference

Chernov, M, Dahlquist, M and Lochstoer, L. 2020. 'Pricing Currency Risks'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=15571