Countercyclical Currency Risk Premia


Hanno Lustig, Ph.D., Nikolai Roussanov, Ph.D., and Adrien Verdelhan, Ph.D.

We describe a novel currency investment strategy, the 'dollar carry trade,' which historically delivered 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 compensated U.S. investors for taking on aggregate risk by shorting the dollar in bad times, when the price of risk is high. The counter-cyclical variation in risk premia can lead 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.


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