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Countercyclical Currency Risk Premia

Author

Listed:
  • Hanno Lustig
  • Nikolai Roussanov
  • Adrien Verdelhan
Abstract
We describe a novel currency investment strategy, the 'dollar carry trade,' which delivers large excess returns, uncorrelated with the returns on well-known carry trade strategies. Using a no-arbitrage model of exchange rates we show that these excess returns compensate U.S. investors for taking on aggregate risk by shorting the dollar in bad times, when the U.S. price of risk is high. The counter-cyclical variation in risk premia leads to strong return predictability: the average forward discount and U.S. industrial production growth rates forecast up to 25% of the dollar return variation at the one-year horizon. The estimated model implies that the variation in the exposure of U.S. investors to world-wide risk is the key driver of predictability.

Suggested Citation

  • Hanno Lustig & Nikolai Roussanov & Adrien Verdelhan, 2010. "Countercyclical Currency Risk Premia," NBER Working Papers 16427, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:16427
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    More about this item

    JEL classification:

    • F3 - International Economics - - International Finance
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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