THE JOURNAL OF FINANCE
VOL. LXXIII, NO. 1
The Share of Systematic Variation in Bilateral
Sorting countries by their dollar currency betas produces a novel cross section of
average currency excess returns. A slope factor (long in high beta currencies and
short in low beta currencies) accounts for this cross section of currency risk premia.
This slope factor is orthogonal to the high-minus-low carry trade factor built from
portfolios of countries sorted by their interest rates. The two high-minus-low risk
factors account for 18% to 80% of the monthly exchange rate movements. The two
risk factors suggest that stochastic discount factors in complete markets’ models
should feature at least two global shocks to describe exchange rates.
HE CORRELATION STRUCTURE OF BILATERAL EXCHANGE RATES
can be summarized
by a small number of principal components, but those principal components
offer a purely statistical description of exchange rates and are difﬁcult to in-
terpret in any micro- or macroﬁnance model. In this paper, in contrast, I report
that two currency risk factors account for a substantial share of individual
exchange rate time series. These factors are priced in currency markets and
the shares of systematic currency risk have implications for any no-arbitrage
model in international ﬁnance.
Two risk factors, namely, carry and dollar, are constructed from portfolios
of currencies. The carry factor corresponds to the change in exchange rates
between baskets of high and low interest rate currencies, while the dollar
factor corresponds to the average change in the exchange rate between the
U.S. dollar and all other currencies. All exchange rates are deﬁned here with
respect to the U.S. dollar. I regress changes in exchange rates on the carry
factor, the same carry factor multiplied by the country-speciﬁc interest rate
difference (the latter is referred to as “conditional carry”), and the dollar factor.
The change in bilateral exchange rate on the left-hand side of these regressions
is measured between t and t+1; on the right-hand side, the carry and dollar
Adrien Verdelhan is with MIT Sloan and NBER. The author thanks the Editor, Ken Sin-
gleton, two anonymous referees, as well as Andrew Atkeson, Nittai Bergman, John Campbell,
Francesca Carrieri, Mike Chernov, Martin Evans, Emmanuel Farhi, Tarek Hassan, Chris Jones,
Pab Jotikasthira, Thomas Knox, Leonid Kogan, Ralph Koijen, David Laibson, Hanno Lustig, Mat-
teo Maggiori, Nelson Mark, Philippe Mueller, Jun Pan, Tarun Ramadorai, Steve Ross, Barbara
Rossi, Nick Roussanov, Lucio Sarno, Piet Sercu, Chris Telmer, Jiang Wang, Ken West, and partic-
ipants at many seminars and conferences for helpful comments and discussions. I have read the
Journal of Finance’s disclosure policy and have no conﬂicts of interest to disclose.