Pricing Ethics in the Foreign Exchange Market: Environmental, Social and Governance Ratings and Currency Premia

Abstract We examine the cross-sectional predictive ability of the Refinitiv Environmental, Social and Governance (ESG) score for returns in the foreign exchange market, using ESG scores aggregated at the national level, and find that ESG is a strong negative predictor of currency returns. Intuitively, investors require a premium for financing low-ESG countries while high-ESG countries offer lower returns and provide a hedge in the bad state of the world. We show that ESG is priced in the cross-section of currency returns. We also consider the different components of ESG and show that its predictability is driven by the environmental pillar of the ESG ratings. Our results have strong implications for portfolios of individual investors and fund managers and offer new insights for policymakers in the foreign exchange market. The profitability of the ESG currency strategy is not driven by the carry trade and is robust to transaction costs.