Reassessing Sources of Risk Premiums in Currency Markets

Mikhail Chernov, Magnus Dahlquist and Lars Lochstoer

No 19470, CEPR Discussion Papers from Centre for Economic Policy Research

Abstract: We show that a small set of emerging markets with floating exchange rates expand the investment frontier substantially relative to G10 currencies. The frontier is characterized by an out-of-sample mean-variance efficient portfolio that prices G10- and emerging markets-based trading strategies unconditionally as well as conditionally. Our approach reveals that returns to prominent trading strategies are largely driven by factors that do not command a risk premium. After real-time hedging of such unpriced risks, the Sharpe ratios of these strategies increase substantially, providing new benchmarks for currency pricing models. For instance, the Sharpe ratio of the carry strategy increases from 0.71 to 1.29. The unpriced risks are related to geographically-based currency factors, while the priced risk that drives currency risk premiums is related to aggregate consumption exposure.

Keywords: Currency; risk; premiums (search for similar items in EconPapers)
JEL-codes: F31 G12 G15 (search for similar items in EconPapers)
Date: 2024-09
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