"In this paper, exposure to global trade risk is seen as a macroeconomic source of vulnerability for countries' economic activity and productivity, impacting the exchange rates. Moreover, global trade risk can be caused by local, country-level, unexpected macroeconomic events that are spread through the demand and supply of goods and services to other countries. This assumption is based on the highly asymmetric international trade structure that limits the extent to which local shocks can cancel each-other through diversication. As different episodes of economic downturn show (e.g. oil crises, financial crises) the slow-down in economic activity is propagated across countries through trade and financial channels. Given limitations on data availability for bilateral financial exposures between countries, we focus on the trade channel by using monthly bilateral trade data for a sample of 37 countries. To our knowledge, this is the first study to offer a macroeconomic explanation to cross-sectional profits made on currency markets."

"A first contribution of this paper is related to the international economics literature and consists in the introduction of a measure for assessing countries' exposure to global trade risk based on the structure of international bilateral trade. This approach allows us to build a pricing factor that accounts for cross-border spillovers and contagion related to the real side of countries' economies. Errico and Massara (2011) offer an analysis of trade interconnectedness as a channel of cross-border transmission of shocks and use it to rank systemically important jurisdictions. They show that the trade-based ranking is similar to the one based on financial interconnectedness. Compared to the previous study, which uses undirected-binary connections, we construct trade-based directed networks and assign weights on each connection, where the weights are computed as the share of trade in the exporter's GDP (further called "normalised trade".) We evaluate the exposure of each country to systemic trade risk by its centrality in the network, which is measured by the principal eigenvector of the trade-based matrix."

"A second contribution of this paper is the proposal of global trade risk as a new common risk factor to account for cross-sectional variation in excess returns made on currency markets. This study is in line with the existing literature on asset pricing, that sees high returns to currency strategies as compensation for risk. For example, Menkho et al. (2012) show that innovations in market volatility can be seen as a state variable against which risk-averse investors wish to hedge. This means that assets with high negative return sensitivity to unexpected changes in volatility should demand higher returns in equilibrium. In this paper we investigate a new source
of risk that is based on macroeconomic fundamentals and nd empirically that low interest rate currencies are seen as a hedge against global trade risk while high interest rate currencies deliver low returns when the global trade risk is high."

"Interestingly, we offer evidence that cross-sectional variation in carry trade excess returns can be partially explained by countries exposure to global trade risk arising from the structure of international trade flows. Results show that high interest rate currencies are negatively related to global trade risk while low interest rate currencies are positively related. This means that high interest rate currencies are negatively exposed to this risk and investors ask for a risk premium as compensation for taking it. Sensitivity analysis indicates that the global trade risk factor is not related to other market-based factors and proves to be a signicant source of risk. "

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