Dynamic Forces behind the Common Currency Risk Factors' Expected Moments

Abstract

This paper examines the association between option-implied distributions of common currency risk factors (dollar ($RX$) and carry ($HML_{FX}$) ) and macroeconomic expectations in form of spread yield curve changes. When currencies are interpreted as an asset price, exchange rates are considered to equal the sum of discounted future macroeconomic fundamentals. The term structure of yield-spreads contains unobservable information about the same expected macroeconomic differentials that drive foreign exchange rates. Using data from G10 currencies, we find a consistent macro-risk based explanation on the common currency risk factors' option-implied moments. These findings are not only important for carry traders, but also contribute to the understanding of currency risk in the cross section.