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Countercyclical Currency Risk Premia

Last Updated on 10 February, 2024 by Rejaul Karim

In the seminal research paper “Countercyclical Currency Risk Premia” authored by Hanno N. Lustig, Nikolai L. Roussanov, and Adrien Verdelhan, a groundbreaking currency investment strategy, the ‘dollar carry trade,’ is unveiled, offering substantial excess returns that are distinct from the well-known carry trade strategies.

This innovative investment approach emerges as an uncorrelated avenue for generating substantial excess returns. Delving into a no-arbitrage model of exchange rates, the study illuminates how these excess returns serve as compensation for U.S. investors, linked to the aggregate risk assumed by shorting the dollar during economic downturns, when the price of risk escalates.

The counter-cyclical fluctuation in risk premia not only elucidates the mechanism behind this approach but also engenders robust return predictability, with forward discounts and U.S. industrial production growth rates predicting a significant portion of the dollar return variation at the one-year horizon.

This trailblazing research not only unveils a novel currency investment strategy but also enriches our understanding of the intricate dynamics of risk premia in shaping the currency market landscape.

Abstract Of Paper

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 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.

Original paper – Download PDF

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Author

Hanno N. Lustig
Stanford Graduate School of Business; National Bureau of Economic Research (NBER)

Nikolai L. Roussanov
University of Pennsylvania – The Wharton School; National Bureau of Economic Research (NBER)

Adrien Verdelhan
National Bureau of Economic Research (NBER); Massachusetts Institute of Technology (MIT) – Sloan School of Management

Conclusion

The profound insights delineated in “Countercyclical Currency Risk Premia” by Hanno N. Lustig, Nikolai L. Roussanov, and Adrien Verdelhan have unraveled an innovative currency investment strategy, the ‘dollar carry trade,’ which stands as an independent nexus for generating substantial excess returns.

The revelation that these excess returns serve as compensation for U.S. investors, aligned with aggregate risk by shorting the dollar during periods of economic downturns, echoes the profound influence of the counter-cyclical variation in risk premia on the currency market landscape.

Furthermore, the robust return predictability furnished by the study, with forward discounts and U.S. industrial production growth rates foretelling a substantial portion of the dollar return variation at the one-year horizon, offers a paradigm-shifting perspective that illuminates the intricate dynamics at play in shaping currency risk premia.

This pioneering research not only unveils a transformative currency investment strategy but also offers invaluable insights into the multifaceted mechanisms underpinning risk premia, making a substantial and innovative contribution to the realm of financial economics.

Related Reading:

Forward and Spot Exchange Rates in a Multi-Currency World

US Dollar Carry Trades in the Era of ‘Cheap Money’

FAQ

Q1: What is the main contribution of the research paper “Countercyclical Currency Risk Premia” by Hanno N. Lustig, Nikolai L. Roussanov, and Adrien Verdelhan?

A1: The main contribution of the research paper is the introduction of a novel currency investment strategy called the ‘dollar carry trade.’ This strategy delivers substantial excess returns that are uncorrelated with returns on well-known carry trade strategies. The paper explains how these excess returns compensate U.S. investors for taking on aggregate risk by shorting the dollar during economic downturns, when the price of risk is high. The study sheds light on the counter-cyclical variation in risk premia and its influence on the currency market, providing insights into the mechanisms behind the ‘dollar carry trade.’

Q2: What distinguishes the ‘dollar carry trade’ from other well-known carry trade strategies?

A2: The ‘dollar carry trade’ is distinguished from other well-known carry trade strategies by delivering large excess returns that are uncorrelated with returns on those strategies. While traditional carry trades involve borrowing in low-interest-rate currencies and investing in high-interest-rate currencies, the ‘dollar carry trade’ involves shorting the dollar during economic downturns, providing an alternative avenue for generating excess returns.

Q3: How do excess returns in the ‘dollar carry trade’ compensate U.S. investors, according to the paper?

A3: Excess returns in the ‘dollar carry trade’ compensate U.S. investors by serving as compensation for taking on aggregate risk. Specifically, these returns are linked to the risk associated with shorting the dollar during bad economic times when the price of risk is high. The counter-cyclical variation in risk premia is a key factor that contributes to the compensation mechanism for U.S. investors engaged in the ‘dollar carry trade.’

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