Uncovered Interest Rate Parity: A Relation to Global Trade Risk

Abstract

The paper gives evidence of a novel pricing factor for the cross-section of carry trade returns based on trade relations between countries. In particular, we apply network theory on countries' bilateral trade to construct a measure for countries' exposure to a global trade risk. A high level of exposure to global trade risk implies that the economic activity in one country is highly dependent on the economic activity of its trade partners and on aggregate trade flow, which reflects in carry trade returns. We find empirically that low interest rate currencies are seen by investors as a hedge against global trade risk while high interest rate currencies deliver low returns when global trade risk is high. These results provide evidence on the underlying macroeconomic sources of systematic risk in currency markets.