Mikhail Chernov, University of California-Los Angeles
Magnus Dahlquist, Stockholm School of Economics
Lars Lochstoer, University of California-Los Angeles
Abstract: We show that a small set of emerging markets with floating exchange rates expand the investment frontier substantially relative to G10 currencies. The frontier is characterized by an out-of-sample mean-variance efficient portfolio that prices G10- and emerging markets-based trading strategies unconditionally as well as conditionally. Our approach reveals that returns to prominent trading strategies are largely driven by factors that do not command a risk premium. After real-time hedging of such unpriced risks, the Sharpe ratios of these strategies increase substantially, providing new benchmarks for currency pricing models. For instance, the Sharpe ratio of the carry strategy increases from 0.71 to 1.29. The unpriced risks are related to geographically-based currency factors, while the priced risk that drives currency risk premiums is related to aggregate consumption exposure.
Discussant: Thomas Maurer, University of Hong Kong
Ivan Shaliastovich, University of Wisconsin-Madison
Stavros Zenios, Durham University
Abstract: Country risk premia reflect compensation for global political risk. A strong factor structure in political-risk sorted equity, bond, and currency portfolios gives rise to a global political risk P-factor, which commands a significant risk premium of 4.4% with a Sharpe ratio of 0.7. Along with the global market, it explains up to three-quarters of the cross-sectional variation within and across a large panel of international asset returns. The P-factor is distinct from existing asset pricing factors, is pervasive across asset classes and political ratings, and is related to systematic variations in expected global growth and aggregate volatility.
Discussant: Sofonias Alemu Korsaye, Johns Hopkins University
Leonid Kogan, Massachusetts Institute of Technology
Dimitris Papanikolaou, Northwestern University
Abstract: We document a strong positive correlation between U.S. innovation and the growth of the real
dollar index. Examining wealth fluctuations across countries, we observe a (re)connection between
exchange rate movements and relative changes in aggregate quantities, such as consumption
and output growth, once wealth changes are controlled for. Moreover, relative wealth changes
are positively correlated with aggregate quantities. In addition, we find that U.S. innovation is
associated with an increase in foreign capital inflows at both the aggregate and firm levels. These
observations motivate our theoretical analysis of how technological innovation affects exchange
rate movements. We introduce a minimal deviation from the standard endowment economy
model of exchange rate: in an economic boom, new firms are created, but they are randomly
distributed to a small part of the population. Our calibrated model successfully replicates key
features of the data, specifically, the joint dynamics of exchange rates, stock returns, real output
and consumption growth, and trade flows.
