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Common Risk Factors in Currency Markets

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What they found

The authors built currency portfolios sorted by interest rate for 35 currencies from 1983 to 2009 and showed that two factors explain their returns: a dollar factor (the average return of all currencies against the dollar) and a carry factor (high-interest minus low-interest currencies, which they call HML-FX). High-interest currencies load positively on the carry factor and low-interest currencies negatively, so the carry factor captures a global risk that hurts high-yield currencies in bad times. The carry premium in this framework is compensation for exposure to global shocks.

See it drawn

Original diagrams for the ideas on this page. Illustrative, not real market data.

Contango and backwardationTwo futures curves against contract expiry: one rising above spot, one falling below it.The same commodity, priced for delivery at different dates.78.0076.0074.0072.0070.00Futures pricespot+1m+2m+3m+4m+5m+6mMonths until the contract expiresspot price74.00CONTANGOlater contracts cost more than spotBACKWARDATIONlater contracts cost less than spot
Contango and backwardation. A futures curve shows what buyers will pay for delivery in one month, two months and so on. When later contracts cost more than the spot price the curve is in contango; when they cost less it is in backwardation.

What you can use

  • Two factors, the dollar and carry, explain most of the systematic variation in currency returns; single-pair analysis misses this structure.
  • The carry factor is a global risk factor; it is what all high-yield currencies share and what makes them fall together.
  • Diversifying across many carry pairs reduces idiosyncratic risk but not exposure to the common carry crash.

Caveats

Factor model rather than a strategy; explains average returns, not timing. Emerging-market currencies have short histories. Technical.

Tags: forex, carry, factor-model, dollar-factor

Summaries are our own reading of the paper, not the authors' words. Educational only, not advice. Discuss it in Book Club.