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We show that a global imbalance risk factor that captures the spread in countries’ external imbalances and their propensity to issue external liabilities in foreign currency explains the cross-sectional variation in currency excess returns. The economic intuition is simple: net debtor countries offer a currency risk premium to compensate investors willing to finance negative external imbalances because their currencies depreciate in bad times. This mechanism is consistent with exchange rate theory based on capital flows in imperfect financial markets. We also find that the global imbalance factor is priced in cross-sections of other major asset markets.
|Additional Information:||This is a pre-copyedited, author-produced PDF of an article accepted for publication in Review of Financial Studies following peer review. The version of record, Sarno, L., Menkhoff, L., Schmeling, M. & Schrimpf, A. Currency Value. The Review of Financial Studies, will be available online at: http://dx.doi.org/10.1093/rfs/hhw067|
|Uncontrolled Keywords:||Currency Premia; Global Imbalances; Currency Excess Returns; Carry Trade|
|Subjects:||H Social Sciences > HG Finance|
|Divisions:||Cass Business School > Faculty of Finance|
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