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Corruption, Carry Trades, and the Cross Section of Currency Returns

Last Updated on 10 February, 2024 by Rejaul Karim

In the pioneering research paper “Corruption, Carry Trades, and the Cross Section of Currency Returns” by Klaus Grobys and Jari-Pekka Heinonen, a groundbreaking exploration into the influence of perceived corruption on the FX market is unveiled.

The study uncovers that currencies originating from countries perceived to be grappling with high levels of corruption yield notably lower returns when juxtaposed with currencies from nations perceived to demonstrate lower levels of corruption.

Furthermore, the correlation between the portfolio spread and NBER recessions along with U.S. consumption growth of nondurable goods underscores the profound implications of corruption perceptions on currency returns.

An intriguing revelation emerges as the stochastic discount factor model analysis establishes the utility of the portfolio spread in pricing the cross-section of currency returns, transcending the influence of standard FX risk factors.

This pioneering research not only sheds light on the multifaceted impact of corruption on currency markets but also offers a transformative lens through which to comprehend the intricate dynamics of currency returns.

Abstract Of Paper

This is the first paper to explore the effects of perceived corruption on the FX market. It finds that the currencies of countries perceived to suffer from high levels of corruption generate statistically significantly lower returns than the currencies of countries perceived to have low levels of corruption. Moreover, the portfolio spread is highly correlated with NBER recessions and U.S. consumption growth of nondurable goods. Interestingly, stochastic discount factor model analysis reveals that the portfolio spread is useful for pricing the cross section of currency returns, even when controlling for standard FX risk factors.

Original paper – Download PDF

Here you can download the PDF and original paper of Corruption, Carry Trades, and the Cross Section of Currency Returns.

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Author

Klaus Grobys
University of Vaasa; University of Jyväskyla

Jari-Pekka Heinonen
University of Vaasa – Department of Accounting and Finance

Conclusion

The captivating findings presented in “Corruption, Carry Trades, and the Cross Section of Currency Returns” by Klaus Grobys and Jari-Pekka Heinonen have unravelled the far-reaching effects of perceived corruption on the FX market, underscoring its profound implications for the cross-section of currency returns.

The discerning revelation that currencies hailing from countries perceived to be steeped in high corruption levels yield substantially lower returns compared to currencies from nations perceived to embody lower corruption levels offers a compelling insight into the intricate interplay between corruption perceptions and currency markets.

Furthermore, the correlation between the portfolio spread and NBER recessions, as well as U.S. consumption growth of nondurable goods, unearths the intricate relationship between corruption and economic conditions, amplifying the far-reaching implications of corruption on currency returns.

The identification of the portfolio spread as a valuable pricing tool for the cross-section of currency returns, notwithstanding the influence of standard FX risk factors, offers a transformative perspective that enriches our understanding of the multifaceted dynamics at play in the domain of currency markets, making a profound and innovative contribution to the field of international finance.

Related Reading:

Countercyclical Currency Risk Premia

Forward and Spot Exchange Rates in a Multi-Currency World

FAQ

Q1: What is the main finding of the research paper “Corruption, Carry Trades, and the Cross Section of Currency Returns” by Klaus Grobys and Jari-Pekka Heinonen?

A1: The main finding of the research paper is that currencies from countries perceived to have high levels of corruption generate significantly lower returns compared to currencies from countries perceived to have low levels of corruption. This suggests that perceived corruption has a notable impact on the cross-section of currency returns in the foreign exchange market.

Q2: How does the research paper establish the connection between perceived corruption and currency returns?

A2: The research paper establishes the connection between perceived corruption and currency returns by examining the returns of currencies from countries with varying levels of perceived corruption. It finds that currencies from countries with high levels of perceived corruption exhibit lower returns, while currencies from countries with low levels of perceived corruption tend to have higher returns. This suggests that corruption perceptions play a role in influencing the performance of currencies in the FX market.

Q3: What additional insights are provided by the correlation between the portfolio spread and NBER recessions, as well as U.S. consumption growth of nondurable goods?

A3: The correlation between the portfolio spread and NBER recessions, as well as U.S. consumption growth of nondurable goods, offers additional insights into the broader economic implications of perceived corruption on currency returns. It indicates that corruption perceptions are correlated with economic conditions, highlighting the interconnectedness between corruption, macroeconomic factors, and currency market dynamics.

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