Currency Return Dynamics: What Is the Role of US Macroeconomic Regimes?
Date:
Revise and Resubmit, Journal of Financial and Quantitative Analysis
This paper investigates the influence of U.S. macroeconomic fundamentals on currency risk premia. We develop a regime-switching model that endogenously detects macroeconomic regimes and estimates regime-specific models. The empirical analysis identifies significant regime shifts, revealing three recurring regimes driven by U.S. inflation and interest rate trends. First, the Forward premium is a prominent characteristic across all regimes, while the importance of Value and Momentum varies. Second, high-inflation regimes are linked to currency mispricing and elevated idiosyncratic volatility. Finally, we identify a new source of predictability tied to macroeconomic regime shifts, unexplained by conventional factor models.
Paper: SSRN link