Currency Excess Returns and Global Downside Market Risk

Sensitivity to downside risk in global stock markets, i.e. exposure to the global stock market when it is falling, is priced in average currency excess returns. Upside risk, exposure to a rising global stock market, is not. Differences in the sensitivity to global downside risk explain more than 40% of the cross-sectional dispersion in 20 monthly currency excess returns from the U.S. investor’s perspective during the sample period from January 1999 to March 2012. Moreover, we show that exposure to a recently proposed “carry trade” risk factor for currency excess returns reflects global downside risk.