Dollar and Carry Redux

Contrary to existing literature, we establish that two factors, dollar and carry, suffice to explain a large cross-section of currency returns with R2s exceeding 80%. Our paper highlights the importance of accounting for time-variation in conditional moments. Unconditional estimations that ignore this time-variation mistakenly reject the two factor model. We propose a parsimonious framework to estimate conditional currency factor models and provide testable restrictions. Our findings imply that currency markets are well described by a model in which (i) each country-specific SDF loads on one country-specific-dollar-and one global-carry-shock, and (ii) risk loadings are time-varying. Other risk factors proposed in the literature are useful to describe the time variation in dollar and carry factor risk premia. in conditional moments of DOL and CAR and conditional factor loadings.

Recommended citation: Liu, Sining and Maurer, Thomas Andreas and Vedolin, Andrea and Zhang, Yaoyuan, Dollar and Carry Redux * (July 1, 2022). Available at SSRN: https://ssrn.com/abstract=4150881 or http://dx.doi.org/10.2139/ssrn.4150881
Download Paper