FX risk premium and consumption growth

The FX world has been dominated by the carry trade which is actually at odds with the basic concept of uncovered interest rate parity. Under the theory of uncovered interest rate parity, currencies with high interest rates should depreciate not appreciate. In reality, the opposite effect holds whereby high interest currencies appreciate or do not depreciate enough relative to the gain on interest rates and low interest currencies. The question is why does this carry trade advantage hold. A logical answer is that the excess return has to be related to compensation for risk taken from holding these currencies.

One way to look at this problem is to compare it to traditional asset pricing theory and determine whether these pricing models can explain what is going on in the currency markets. Modern pricing models have moved beyond capital asset pricing to consumption based pricing models. Under the consumption-based approach to asset pricing, the excess returns from an asset should be related to the consumption pattern risk of investors. Investors would like to have assets that will smooth out their income to match the changes in their consumption growth.

An asset that declines in price when consumption is low is risky. To hold this asset, the investor must be compensated for the risk. Investors would be willing to pay more for those assets which provide better return when consumption is growth is low. They will not pay for assets that have low returns when consumption growth is low. Investors want to be compensated with excess return for those assets which have low returns when consumption growth is low.

This concept of compensation for holding risky assets which have low returns when consumption is low can be tested in the FX markets. The key is testing this idea conditional on the level of interest rates. What some researchers have found in an innovative paper (Hanng Lustig and Adrien Verdelhan in ‘The cross section of foreign currency risk premia and consumption growth risk” American Economic Review March 2007) is that the excess return in high yielding currencies is compensation to US investors for taking on more US consumption growth risk. The researchers show that the variation in excess returns for exchange rates conditional on the level of interest rates is related to the consumption betas for the currencies and therefore the pattern of consumption growth in the US.

The performance of the carry trade is related to consumption risk. The consumption beta for high yielding currencies is high; consequently, investors need to be given a premium to hold this currency. The consumption beta is small or negative for low yielding currencies versus the level for high yielding currencies. Put in practical terms, the high interest rate currencies relative to the US will depreciate against the dollar when US consumption growth is low, consistent with the consumption based capital asset pricing model. Similarly, low yielding currency countries will depreciate when US consumption is high.

This has interesting implications for carry trades if there is a slowdown in US growth. A US slowdown may actually lead to a situation where investors will prefer the lower yielding currencies relative to high yielding currencies. This is not consistent with the carry trade mentality that has existed over the last few years which blindly holds high yielding currencies. US growth is now increasing, so this model may not be put to the test in the near-term. Beware of carry trades. They are not something that will last forever if there is a significant change in consumption growth. Fundamentals and the pricing of risk do matter.