Growth Opportunities, Investment Propensity and Currency Risk Premia

Abstract: Recent studies have found a link between exchange rate returns and macroeconomic imbalances. However, focusing mainly on standard fundamentals might not identify the true drivers of an economy's future repayment ability and therefore currency risk. In order to test two more intricate characteristics that potentially add to a currency's riskiness, I propose a beta pricing model with two factors. The investment factor captures risk that results from the coincidence of current account deficits and a high propensity to use capital inflows on consumption rather than investment. The growth opportunities factor proxies for the perceived risk of poor future economic growth due to an unfavorable industry mix. In asset pricing tests, I confirm my hypothesis that both types of risk are priced. Current account deficit countries with low investment spending offer higher returns to currency investors. The same is true for countries with a large share of low-growth industries. Taken together, the two factors are able to explain more than two thirds of the cross-sectional variation in currency excess returns.