The authors examine whether real exchange rates truly identify undervalued and overvalued currencies and find that traditional purchasing power parity measures can be misleading. Adjusting for productivity and export quality better explains currency returns, with fair value measures producing stronger exchange rate reversals and more consistent excess return predictability.
Currency Value
Lukas Menkhoff, Lucio Sarno
Research
58 Pages
Key Takeaways
Traditional PPP Limits: Real exchange rate portfolios earned 1.62% annualized excess returns, but weak currencies subsequently depreciated by 3.14%, contradicting conventional value investing intuition.
Fair Value Improves: Adjusting for productivity and export quality increased annualized excess returns to 2.56%, while exchange rate appreciation contributed 2.75%, aligning returns with genuine valuation reversion.
Macro Drivers Matter: Currency value portfolios based on expected output gaps produced a 2.09% annualized excess return with a 0.76 Sharpe ratio, highlighting macro fundamentals as key risk premium drivers.
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