Countercyclical Currency Risk Premia
Currency excess returns are predictable, more than stock returns, and about as much as bond returns. 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 on baskets of foreign currency are strongly counter-cyclical because they inherit the cyclical properties of the average forward discount. This counter-cyclical dollar risk premium compensates U.S. investors for taking on U.S.-specific risk in foreign exchange markets by shorting the dollar. Macroeconomic variables such as the rate of U.S. industrial production growth increase the predictability of average foreign currency excess returns even when controlling for the forward discount.
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