Benchmark Currency Stochastic Discount Factors

We examine the pricing performance of out-of-sample pricing factors in the broad cross-section of currency returns. To this end, we develop a methodology for estimating empirical minimum-entropy stochastic discount factors (SDFs) under economically-motivated constraints on position leverage. Our empirical SDFs deliver superior out-of-sample fit and smaller pricing errors than existing factor models in the cross-section of currency portfolio returns, and are priced in individual currency and hedge fund cross-sections. After transaction costs, an investable SDF portfolio delivers a Sharpe ratio of around 0.8 and positively skewed returns. These empirical SDFs offer tractable benchmarks for candidate currency pricing models.