The authors examine why currencies with higher interest rates historically delivered higher excess returns. They link those returns to weaker performance when US consumption growth slows, suggesting compensation for economic risk. Their explanation requires unusually high investor risk aversion, raising questions about its plausibility.
The Cross-Section of Foreign Currency Risk Premia and Consumption Growth Risk
Adrien Verdelhan, Hanno Lustig
Research
51 Pages
Key Takeaways
Currency Return Gap: Average excess returns ranged from negative 2.3% for low interest rate currencies to positive 3% for high interest rate currencies.
Consumption Risk Matters: Consumption models explained up to 80% of the variation in average excess returns across eight currency portfolios.
Demanding Risk Assumptions: The estimated risk aversion coefficient was around 100, exceeding levels most economists consider plausible.
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