Finance Brown Bag Seminar
Speaker: Tarek Hassan, University of Chicago, NBER and CEPR
Title: Forward and Spot Exchange Rates in a Multi-Currency World
Abstract: We decompose the covariance of currency returns with forward premia into a “cross-currency”, a “between time and currency”, and a “cross—time” component. The surprising result of our decomposition is that the cross-currency and cross-time-components account for almost all systematic variation in expected currency returns, while the `between time and currency’ component is statistically and economically insignificant. This finding has a number of surprising implications for models of currency risk premia. First, it shows that the two most famous anomalies in international currency markets, the “carry trade” and the Forward Premium Puzzle (FPP), are separate phenomena that may require separate explanations. The carry trade is driven by persistent differences in currency risk premia across countries, while the FPP is driven by time-series variation in all currency risk premia against the US dollar. Second, it shows that both the carry trade and the FPP are puzzles about asymmetries in the risk characteristics of countries. The carry trade results from persistent differences in the risk characteristics of individual countries; the FPP is the result of time variation in the average return of all currencies against the US dollar. As a result, existing models in which two symmetric countries interact in financial markets cannot explain either of the two anomalies.