The paper analyses the macro-financial determinants of the risk-return trade-off inherent in currency investment strategies. It uses a novel econometric method that allows us to estimate the stochastic discount factor for the currency market and the risk premiums of more than 100 candidate risk factors that could explain the returns of many investment strategies, while allowing for both omitted-variable and measurement-error biases.
The results show that the stochastic discount factor that best explains the risk-return profile of currency investment strategies mainly reflects the behaviour of the US dollar factor and the currency differentials in the short-term interest rates and in the recent performances. Moreover, among the long list of candidate risk factors, only those that capture volatility, uncertainty and liquidity conditions show a statistically significant risk premium.
