DP15571 Pricing Currency Risks

Author(s): Mikhail Chernov, Magnus Dahlquist, Lars Lochstoer
Publication Date: December 2020
Date Revised: February 2021
Keyword(s): currency risk premiums, factor models, Stochastic discount factor
JEL(s): F31, G12, G15
Programme Areas: Financial Economics, International Macroeconomics and Finance
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=15571

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.