The currency market features a relatively small cross-section and conditional expected returns can be characterized by only a few signals – interest differentials, trend, and mean-reversion. For those who missed it, we provide a synopsis of Magnus Dahlquist’s presentation on his research ‘Pricing Currency Risks’ (co-authored by Mikhail Chernov and Lars A. Lochstoer), which sets out to explain how these properties are exploited to construct a conditional projection of the stochastic discount factor onto excess returns of individual currencies.
1. What is the paper about?
We characterize currency returns by a few signals—the interest differential, a short-term trend, and long-term mean-reversion. A dynamic portfolio is constructed in real time that correctly prices individual currencies out of sample. We find that this portfolio also prices common investment strategies (such as carry, momentum, and value) in the currency market.
We decompose the investment strategies into a priced component and an unpriced component and show that the lion share of the investment strategies’ return movements is unpriced. Our results question extant explanations of investment strategies based on intermediary capital or global volatility and support explanations based on economic growth. In sum, our analysis helps in understanding currency risk pricing.
2. What are the practical implications for practitioners?
Our findings highlight the risk-return tradeoffs in the currency markets. The results show that asset managers can more effectively construct currency strategies and generate returns with higher Sharpe ratios than with common carry, momentum, and value strategies. Relatedly, results also show that asset managers can more effectively hedge away currency movements that they are not compensated for. More broadly, our findings may guide practitioners in their tactical asset allocations and be used in performance evaluation analyses of global portfolios.