Insights From The World’s Top Academic FX Researcher

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Last week I had the privilege of co-hosting Behind the Markets with my friend Jeremy Schwartz. We had the honor of sitting down with one of my University of Chicago PhD classmates, Nick Roussanov.

Nick has gone on to become a stellar academic and is currently tenured at The Wharton School (not too shabby!).

Our conversation is here.

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If you ever wanted to dig deep into understanding and thinking about currency/FX risk in your portfolio, I highly recommend you give the podcast a listen. You can fast forward through the times when Jeremy and I are talking, but make sure you listen to Nick in super slow-motion.

I can genuinely say that I learned a lot from reading Nick’s research. Here are a few research key research papers Nick has written on the subject of currency:

One of his earlier co-authored papers is equivalent to the “Fama and French 1992” paper for equity markets and explains what drives FX returns — in short, the “carry trade,” or HML_FX, is arguably a risk factor and explains a lot of the returns associated with FX. Not earth shattering news to some, but a formal study on the subject.

Common Risk Factors in Currency Markets

We identify a ‘slope’ factor in exchange rates. High interest rate currencies load more on this slope factor than low interest rate currencies. This factor accounts 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 next few papers try and understand why the carry trade is arguably a risk factor. The short answer is that high carry currencies are typically associated with commodity producing countries and this drives the underlying risk of the carry trade. Again, perhaps not earth shattering news to market pontificators, because this is a story that has been told by many practitioners, but it is nice to see a formal study on the subject that is subject to intense peer-review.

Commodity Trade and the Carry Trade: A Tale of Two Countries

Persistent interest rate differentials account for much of the currency carry trade profitability. “Commodity currencies” offer high interest rates on average, while countries that export finished goods tend to have low interest rates. We develop a general equilibrium model of international trade and currency pricing where countries have an advantage in producing either basic inputs or final goods. In the model domestic production insulates commodity-producing countries from global productivity shocks, forcing final-good producers to absorb them. Commodity-currency exchange rates and risk premia increase with productivity differentials and trade frictions. These predictions are strongly supported in the data.

Here is a chart from the paper highlighting the relationship between import ratios and 1) interest rate spreads and 2) FX excess returns:

Nick has a bunch more research at his site.

I highly encourage all geeks to check it out.

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Article by Wesley R. Gray, Ph.D., Alpha Architect

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