• September 2011, pdf.
• Abstract: Changes in exchange rates are not random. Two factors account for 20% to 90% of the monthly exchange rate movements in developed countries. If these two factors were known one period in advance, mean squared errors would be a fraction of those obtained assuming that exchange rates are random walks. Across countries, the more integrated the equity and bond markets, the higher the share of systematic currency variation. These results have direct implications for asset managers, motivate further work on exchange rates, and oer new insights into international economics and finance models.

• With Hanno Lustig and Nick Roussanov, November 2010 pdf.
• Abstract: The average forward discount of the dollar against developed market currencies is the best predictor of average foreign currency excess returns earned by U.S. investors on a long position in a large basket of foreign currencies and a short position in the dollar. The predicted excess returns are strongly connected to the U.S. business cycle, and increase dramatically during U.S. recessions as the average forward discount increases. Adding the rate of U.S. industrial production growth as a predictor increases the predictability of foreign currency returns to 30% at the 12-month horizon. Using a no-arbitrage model of exchange rates we show that the counter-cyclical dollar risk premium reflects time-varying compensation to U.S. investors for taking on U.S. specific risk by shorting the dollar. The model implies that predictability of exchange rate changes, as opposed to excess returns, is much harder to detect in small samples, as is the case in the data.

• With Hanno Lustig and Stijn Van Nieuwerburgh, June 2010, pdf.
• Abstract: We set up an exponentially affine stochastic discount factor model for bond yields and stock returns in order to estimate the prices of aggregate risk. We use the estimated risk prices to compute the no-arbitrage price of a claim to aggregate consumption. The price-dividend ratio of this claim is the wealth-consumption ratio. Our estimates indicate that total wealth is much safer than stock market wealth. The consumption risk premium is only 2.2 percent, substantially below the equity risk premium of 6.9 percent. As a result, the average US household has more wealth than one might think; most of it is human wealth. Nearly all of the variation in total wealth can be traced back to changes in long-term real interest rates. Contrary to conventional wisdom, we find that events in bond markets, not stock markets, matter most for understanding fluctuations in total wealth.

• With Nicola Borri, September 2011 pdf (appendix, data).
• Winner of the WRDS Best Paper Award, EFM 2010.
• Abstract: Emerging countries tend to default when their economic conditions worsen. If harsh economic conditions in an emerging country correspond to similar conditions for the U.S. investor, then foreign sovereign bonds are particularly risky. We explore how this mechanism impacts the data and influences a general equilibrium model of optimal borrowing and default. Empirically, the higher the correlation between past foreign bond and U.S. market returns, the higher the average sovereign excess returns. In the model, sovereign defaults and bond prices depend not only on the borrowers' economic conditions, but also on the lenders' time-varying risk aversion.

• With Emmanuel Farhi, Samuel Fraiberger, Xavier Gabaix and Romain Ranciere, June 2009, pdf (appendix).
• Abstract: How much of carry trade excess returns can be explained by the presence of disaster risk? To answer this question, we propose a simple structural model which includes both Gaussian and disaster risk premia and can be estimated even in samples that do not contain disasters. The model points to a novel estimation procedure based on currency options with potentially different strikes. We implement this procedure on a large set of countries over the 1996-2008 period, forming portfolios of hedged and unhedged carry trade excess returns by sorting currencies on their forward discounts. We find that disaster risk premia account for about 25% of carry trade excess returns in developed countries.

Published Papers

• With Francois Gourio and Michael Siemer, September 2011, Journal of International Economics, forthcoming, pdf (appendix).
• Abstract: This paper studies a two-country real business cycle model with two novel features: (1) exogenous shocks to worldwide uncertainty, (2) heterogeneous exposures of countries to a world aggregate shock. When world risk increases, investment falls and a worldwide recession ensues, even in the absence of technology shocks. Equity prices and interest rates fall, especially in the more risky country, and the high interest rate currency depreciates. The model generates a low correlation between relative consumption growth and exchange rates, a large forward premium, and "excess comovement" of asset prices relative to quantities. Empirically, we measure the response of macroeconomic aggregates and exchange rates to an aggregate volatility shock, and nd support for the model mechanism.

• With Hanno Lustig, September 2011, Journal of Monetary Economics, conditionally accepted, pdf.
• Abstract: We measure the variation in realized returns in bond and equity markets over the business cycle. In each of these markets, the equity, government bond and corporate bond markets, the realized Sharpe ratio is much higher in recessions than in expansions. However, the variation in realized Sharpe ratios during expansions (recessions) differs across securities markets. The realized Sharpe ratio on equity increases monotonically during recessions to reach a maximum of 1.1 at the trough of a business cycle, and it declines monotonically during expansions to reach a minimum of -0.2 at the peak. In bond markets, the realized Sharpe ratios are lowest (highest) at the trough (peak) and increase (decrease) almost monotonically during expansions (recessions), with values ranging from 0 to 0.7. These results are consistent with large increases (decreases) in actual equity risk premia and Sharpe ratios during recessions (expansions).

• With Hanno Lustig and Nick Roussanov, May 2011, Review of Financial Studies, forthcoming, (pdf, data).
• Winner of the Terker Prize in Investment Research, 2009.
• Abstract: We identify a `slope' factor in exchange rates. High interest rate currencies load more on this slope factor than low interest rate currencies. As a result, this factor can account for most of the cross-sectional variation in average excess returns between high and low interest rate currencies. A standard, no-arbitrage model of interest rates with two factors -- a country-specific factor and a global factor -- can replicate these findings, provided there is sufficient heterogeneity in exposure to global or common innovations. We show that our slope factor identifies these common shocks, and we provide empirical evidence that it is related to changes in global equity market volatility. By investing in high interest rate currencies and borrowing in low interest rate currencies, US investors load up on global risk.

The Cross-Section of Foreign Currency Risk Premia and US Consumption Growth Risk: A Reply

• With Hanno Lustig. American Economic Review, December 2011, Vol. 101, pp. 3477-3500 (pdf).
• Abstract: The consumption growth beta of an investment strategy that goes long in high interest rate currencies and short in low interest rate currencies is large and significant. The price of consumption risk is significantly different from zero, even after accounting for the sampling uncertainty introduced by the estimation of the consumption betas. The constant in the regression of average returns on consumption betas is not significant. In addition, the consumption and market betas of this investment strategy increase during recessions and times of crisis, when risk prices are high, implying that the unconditional betas understate its riskiness. We use the recent crisis as an example.

• With George J. Jiang and Ingrid Lo, Journal of Financial and Quantitative Analysis, Vol. 46, No. 2, Apr. 2011, pp. 527–551 (pdf).
• Abstract: In this paper, we identify jumps in U.S. Treasury-bond (T-bond) prices and investigate the causes of such unexpected large price changes. In particular, we examine the relative importance of macroeconomic news announcements versus variation in market liquidity in explaining the observed jumps in the U.S. Treasury market. We show that while jumps occur mostly at prescheduled macroeconomic announcement times, announcement surprises have limited power in explaining bond price jumps. Our analysis further shows that pre- announcement liquidity shocks, such as changes in the bid-ask spread and market depth, have significant predictive power for jumps. The predictive power is significant even after controlling for information shocks. Finally, we present evidence that post-jump order flow is less informative relative to the case where there is no jump at announcement.

• With Ralph Koijen, Hanno Lustig, and Stijn Van Nieuwerburgh, American Economic Review, Papers and Proceedings, May 2010, Vol. 100, No 2, pp 552-556 (pdf).
• Abstract: We show that the long-run risk model, which is successful at matching the wealth-consumption ratio, high equity risk premium and the nominal yields at
  short maturities implies too little (much) variation in the martingale component of the nominal (real) pricing kernel. This is because the nominal bond risk premium at infinite horizon is too high, or in other words because the real bond risk premium at infinite horizon is too low and thus the inflation risk premium too high. We conclude that the wealth-consumption ratio, the equity risk premium, and the long horizon bond risk premium impose tight restrictions on dynamic asset pricing models.
• Appendix (pdf).

• First Version: November 2003, This Version: October 2008, pdf.
• Journal of Finance, February 2010, Vol. 65, No 1, pp 123-145.
• Abstract: This paper presents a model that reproduces the uncovered interest rate parity puzzle using on endogenous counter-cyclical risk premia and pro-cyclical real interest rates. Investors have preferences with external habits. During bad times at home, when domestic consumption is close to the habit level, the pricing kernel is volatile, and the representative investor is very risk-averse. When the domestic investor is more risk-averse than her foreign counterpart, the exchange rate is closely tied to domestic consumption growth shocks, and the domestic investor expects a positive currency excess return. Since interest rates are low in bad times, expected currency excess returns increase with interest rate differentials.
• Appendix (pdf) : In this appendix, I derive the optimal foreign and domestic consumption allocations in a two-country model where agents are characterized by habit preferences. Agents can trade, but incur proportional and quadratic trade costs. This model replicates the empirical forward premium and equity premium puzzle and the interest rates and exchange rates' volatility. Finally, I investigate the role of non tradable goods on the correlation between exchange rates and consumption growth rates.

The Cross-Section of Foreign Currency Risk Premia and US Consumption Growth Risk

• With Hanno Lustig. American Economic Review, March 2007, vol. 97, No 1, pp 89-117, pdf.
• Abstract: Aggregate consumption growth risk explains why low interest rate currencies do not appreciate as much as the interest rate differential and why high interest rate currencies do not depreciate as much as the interest rate differential. We sort foreign currency returns into portfolios based on foreign interest rates, and we test the Euler equation of a domestic investor who invests in these currency portfolios. We find that domestic investors earn negative excess returns on low interest rate currency portfolios and positive excess returns on high interest rate currency portfolios. Because high interest rate currencies depreciate on average when domestic consumption growth is low and low interest rate currencies do not under the same conditions, low interest rate currencies provide domestic investors with a hedge against domestic aggregate consumption growth risk.
• Data.
• Reply to Burnside.

Investing in Foreign Currency is like Betting on your Intertemporal Marginal Rate of Substitution.

• With Hanno Lustig. Journal of the European Economic Association, Papers and Proceedings, April-May 2006, Vol. 4, No. 2-3, pp 644-655, pdf.
• Abstract: Investors earn positive excess returns on high interest rate foreign discount bonds, because these currencies appreciate on average. Lustig and Verdelhan (2005) show that investing in high interest rate foreign discount bonds exposes them to more aggregate consumption risk, while low interest rate foreign bonds provide a hedge. This paper provides a simple model that replicates these facts. Investing in foreign currency is like betting on the difference between your own intertemporal; marginal rate of substitution (IMRS) and your neighbor's IMRS. These bets are very risky if your neighbor's IMRS is not correlated with yours, but they provide a hedge when his IMRS is highly correlated and more volatile. If the foreign neighbors that face low interest rates also have more volatile and correlated IMRS, that accounts for the spread in excess returns in the data.