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Currency Premia and Global Imbalances

Last Updated on 10 February, 2024 by Rejaul Karim

The research paper “Currency Premia and Global Imbalances” delves into the captivating interplay between global imbalances and currency excess returns, significantly enriching our understanding of the multifaceted dynamics of the currency market.

Awarded the Kepos Capital Award for the Best Paper on Investments at the 2013 WFA Meeting, the study sheds light on a compelling global imbalance risk factor that effectively elucidates the cross-sectional variation in currency excess returns.

The paper’s economic intuition is elegantly straightforward, demonstrating how net debtor countries offer a currency risk premium to offset the risk associated with financing negative external imbalances, further elucidating the mechanism that underpins the exchange rate theory in imperfect financial markets.

Notably, the research also unveils the pricing of the global imbalance factor in cross-sections of other major asset markets, underscoring the far-reaching implications of these findings.

This holistic analysis promises to significantly advance our comprehension of currency risk premia, global imbalances, and the intricate relationship between external liabilities and currency excess returns, thereby contributing to the ongoing discourse on investment strategies and currency market dynamics.

Abstract Of Paper

We show that a global imbalance risk factor that captures the spread in countries’ external imbalances and their propensity to issue external liabilities in foreign currency explains the cross-sectional variation in currency excess returns. The economic intuition is simple: net debtor countries offer a currency risk premium to compensate investors willing to finance negative external imbalances because their currencies depreciate in bad times. This mechanism is consistent with exchange rate theory based on capital flows in imperfect financial markets. We also find that the global imbalance factor is priced in cross sections of other major asset markets.

Original paper – Download PDF

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Author

Pasquale Della Corte
Imperial College Business School; Centre for Economic Policy Research (CEPR)

Steven Riddiough
University of Toronto

Lucio Sarno
University of Cambridge – Judge Business School; Centre for Economic Policy Research (CEPR)

Conclusion

In conclusion, “Currency Premia and Global Imbalances” stands as a beacon of insight into the intricate relationship between global imbalances and currency excess returns, significantly advancing our comprehension of the multifaceted dynamics within the currency market.

The revelation of a global imbalance risk factor as a potent explanatory variable for the cross-sectional variation in currency excess returns is a pivotal contribution, offering a profound economic intuition.

The phenomenon where net debtor countries offer a currency risk premium to offset the risk associated with financing negative external imbalances aligns elegantly with exchange rate theory, grounded in the dynamics of capital flows within imperfect financial markets.

Moreover, the study’s discernment of the pricing of the global imbalance factor in cross-sections of other major asset markets underscores the far-reaching implications of these findings. This comprehensive analysis promises to enrich our understanding of currency risk premia, global imbalances, and their implications for investment strategies and currency market dynamics.

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FAQ

Q1: What is the main focus of the research paper “Currency Premia and Global Imbalances”?

A1: The main focus of the research paper is the exploration of the interplay between global imbalances and currency excess returns. It introduces a global imbalance risk factor that effectively explains the cross-sectional variation in currency excess returns, shedding light on the relationship between external imbalances and the currency risk premium.

Q2: What economic intuition does the paper provide for the global imbalance risk factor?

A2: The paper’s economic intuition is elegantly straightforward. It demonstrates that net debtor countries offer a currency risk premium to compensate investors willing to finance negative external imbalances. This compensation is due to the fact that currencies of net debtor countries depreciate in bad times, providing a mechanism consistent with exchange rate theory based on capital flows in imperfect financial markets.

Q3: How does the research contribute to our understanding of currency market dynamics?

A3: The research significantly contributes to our understanding of currency market dynamics by revealing the role of global imbalances in influencing currency excess returns. The introduction of the global imbalance risk factor provides a valuable explanatory variable for cross-sectional variations in currency excess returns. The findings not only enhance our comprehension of currency risk premia but also have broader implications for investment strategies and their relationship with global imbalances.

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