DP9484 Conditional Risk Premia in Currency Markets and Other Asset Classes

Author(s): Martin Lettau, Matteo Maggiori, Michael Weber
Publication Date: May 2013
Date Revised: October 2013
Keyword(s): carry trade, commodity basis, downside risk, equity cross section
JEL(s): F31, F34, G11, G15
Programme Areas: International Macroeconomics, Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=9484

The downside risk CAPM (DR-CAPM) can price the cross section of currency returns. The market-beta differential between high and low interest rate currencies is higher conditional on bad market returns, when the market price of risk is also high, than it is conditional on good market returns. Correctly accounting for this variation is crucial for the empirical performance of the model. The DR-CAPM can jointly explain the cross section of equity, commodity, sovereign bond and currency returns, thus offering a unified risk view of these asset classes. In contrast, popular models that have been developed for a specific asset class fail to jointly price other asset classes.