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May 31, 20260 citationsOpen Access

Essays on the Currency Risk Premium

YLYi Liu

Key Points

  • This dissertation examines how currency risk premiums behave and what factors predict currency excess returns.
  • Analyzed expected bond and currency excess returns across G10 countries using the Cochrane-Piazzesi factor.
  • Estimated Taylor-type interest rate rules for G10 countries to study their effect on currency carry trade returns.
  • Developed an equilibrium asset pricing model incorporating interest rate feedback rules with varying inflation responses.
  • Cochrane-Piazzesi factors predict currency excess returns; higher factors correlate with lower subsequent returns.
  • The study finds a strong connection between heterogeneous inflation responses and currency carry trade returns.
  • A calibrated equilibrium asset pricing model replicated the empirical correlations of observed currency excess returns.

Abstract

In this dissertation, I study the empirical behavior of currency risk premium. I document predictability of currency excess returns in the data, and rationalize the observed predictability in asset pricing models featuring no arbitrage.In Chapter 1, I study joint time variation in expected bond and currency excess returns across G10 countries. Exploiting the documented fact that the Cochrane-Piazzesi factor explains most of the variation in expected bond excess returns, I investigate whether it predict currency excess return as well. I find countrywise differenced Cochrane-Piazzesi factors predicts currency excess returns, both in time-series and cross-sectional. Specifically, countries with higher CP factors tend to have lower subsequent currency excess returns. The predictability survives after various robustness checks. An international affine term structure model rationalizes the predictability.In Chapter 2, I study the role of monetary policy rules in explaining the observed returns from currency carry trades. Following standard practice, I estimate Taylor-type interest rate rules for G10 countries. I find that countries exhibit a heterogeneous degree of inflation response in terms of nominal rate adjustment. This heterogeneity strongly correlates with the returns, risk-adjusted returns, and portfolio positions of the currency carry trade in the data. I find that an equilibrium asset pricing model in which countries commit to interest rate feedback rules with heterogeneous inflation responses can qualitatively replicate these empirical correlations. A calibrated version of the model matches the magnitude of observed moments of the currency excess return.

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Cite This Study

Yi Liu (2026) studied this question.

synapsesocial.com/papers/6a1bd0df5783ba022b6fc837https://doi.org/10.17615/j234-xm41
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