• With Hanno Lustig and Nick Roussanov, June 2008 pdf (appendix).
• Abstract: Currency excess returns are highly predictable, more than stock returns, and about as much as bond returns. In addition, these predicted excess returns are strongly counter-cyclical. The average excess returns on low interest rate currencies are 4.8 percent per annum smaller than those on high interest rate currencies after accounting for transaction costs. We show that a single return-based factor, the return on the highest minus the return on the lowest interest rate currency portfolios, explains the cross-sectional variation in average currency excess returns from low to high interest rate currencies. This evidence suggests currency risk premia are large and time-varying. In a simple affine pricing model, we show that the high-minus-low currency return measures that component of the stochastic discount factor innovations that is common across countries. To match the carry trade returns in the data, low interest rate currencies need to load more on this common innovation when the market price of global risk is high.

• With Hanno Lustig and Stijn Van Nieuwerburgh, May 2008, pdf (appendix) .
• Abstract: To measure the wealth-consumption ratio, we estimate an exponentially affine model of the stochastic discount factor on bond yields and stock returns. We use that discount factor to compute the no-arbitrage price of a claim to aggregate US consumption. Our estimates indicate that total wealth is much safer than stock market wealth. The consumption risk premium is only 2.2 percent, substantially below the equity risk premium of 6.9 percent. As a result, our estimate of the wealth-consumption ratio is much higher than the price-dividend ratio on stocks throughout the post-war period. The high wealth-consumption ratio implies that the average US household has a lot of wealth, most of it human wealth. A variance decomposition of the wealth-consumption ratio shows less return predictability overall, but most of the return predictability is for future interest rates, not excess returns. We conclude that the properties of the total wealth portfolio are more similar to those of a long-maturity bond portfolio than those of a stock portfolio. The differences that we find between the risk-return characteristics of equity and total wealth suggest that equity is a special asset class.

• First Version: November 2003, This Version: June 2008, pdf.
• Abstract: This paper presents a model that reproduces the uncovered interest rate parity puzzle using on endogenous counter-cyclical risk premia and pro-cyclical real interest rates. Investors have preferences with external habits. During bad times at home, when domestic consumption is close to the habit level, the pricing kernel is volatile, and the representative investor is very risk-averse. When the domestic investor is more risk-averse than her foreign counterpart, the exchange rate is closely tied to domestic consumption growth shocks, and the domestic investor expects a positive currency excess return. Since interest rates are low in bad times, expected currency excess returns increase with interest rate differentials.

• This Version: June 2008, pdf.
• Abstract: In this paper, I derive the optimal foreign and domestic consumption allocations in a two-country model where agents are characterized by habit preferences. Agents can trade, but incur proportional and quadratic trade costs. This model replicates the empirical forward premium and equity premium puzzle and the interest rates and exchange rates' volatility. Finally, I investigate the role of non tradable goods on the correlation between exchange rates and consumption growth rates.

Published Papers

The Cross-Section of Foreign Currency Risk Premia and US Consumption Growth Risk

• With Hanno Lustig. American Economic Review, March 2007, vol. 97, No 1, pp 89-117, pdf.
• Abstract: Aggregate consumption growth risk explains why low interest rate currencies do not appreciate as much as the interest rate differential and why high interest rate currencies do not depreciate as much as the interest rate differential. We sort foreign currency returns into portfolios based on foreign interest rates, and we test the Euler equation of a domestic investor who invests in these currency portfolios. We find that domestic investors earn negative excess returns on low interest rate currency portfolios and positive excess returns on high interest rate currency portfolios. Because high interest rate currencies depreciate on average when domestic consumption growth is low and low interest rate currencies do not under the same conditions, low interest rate currencies provide domestic investors with a hedge against domestic aggregate consumption growth risk.
• Data.
• Reply to Burnside (2007).

Investing in Foreign Currency is like Betting on your Intertemporal Marginal Rate of Substitution.

• With Hanno Lustig. Journal of the European Economic Association, Papers and Proceedings, April-May 2006, Vol. 4, No. 2-3, pp 644-655, pdf.
• Abstract: Investors earn positive excess returns on high interest rate foreign discount bonds, because these currencies appreciate on average. Lustig and Verdelhan (2005) show that investing in high interest rate foreign discount bonds exposes them to more aggregate consumption risk, while low interest rate foreign bonds provide a hedge. This paper provides a simple model that replicates these facts. Investing in foreign currency is like betting on the difference between your own intertemporal; marginal rate of substitution (IMRS) and your neighbor's IMRS. These bets are very risky if your neighbor's IMRS is not correlated with yours, but they provide a hedge when his IMRS is highly correlated and more volatile. If the foreign neighbors that face low interest rates also have more volatile and correlated IMRS, that accounts for the spread in excess returns in the data.