Long Run Risks in FX Markets: Are They There?

Abstract

This paper documents a tight connection between long run consumption risks (LRRs), currency excess returns, currency risk premia and the carry trade. We adopt a novel identification strategy that estimates country level LRRs using asset market data alone. With this identification strategy in hand, we find that: (1) currencies that suffer a bad relative LRR shock appreciate on impact before depreciating over the long run, (2) the High-Minus-Low (HML) carry trade sorts currencies on the basis of global LRR exposures, (3) the dollar carry trade outperforms on impact before underperforming over the long run in response to positve US relative LRRs, (4) US relative LRRs drive global currency risk factors. We interpret these facts as evidence in favour of an international LRR model where US LRRs drive global shocks to the world economy.