Currency Returns, Skewness and Crash Risk

Abstract

I identify a global currency skewness risk factor. Currency portfolios that have higher average excess returns co-vary more positively with this risk factor. They suffer losses in bad times for currency investors when high interest rate investment currencies have a greater tendency to depreciate sharply as a group relative to low interest rate funding currencies. Consequently, they earn higher average excess returns as reward for exposure to this risk. I create three sets of sorted currency portfolios reflecting three distinct sources of variation in average excess currency returns. The first set sorts currencies based on interest rate differentials. The second set sorts currencies based on currency momentum. The third set sorts currencies based on currency undervaluedness relative to the benchmark purchasing power parity (PPP) implied exchange rates. Within these sets of sorted currency portfolios, currencies with higher interest rates earn higher average excess returns. Secondly, currencies that are higher momentum currencies (currencies with higher recent excess returns) earn higher average excess returns. Thirdly, currencies that are more undervalued relative to the PPP implied level earn higher average excess returns. I find that differences in exposure to the global currency skewness risk factor can explain the systematic variation in average excess currency returns within all three groups of portfolios much better than existing foreign exchange risk factors in the literature.