Related to #5 – FX Carry Trade

Author: Kesse

Title: Exchange Rates, Carry Trade Returns and Political Risks

Link: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2813028

Abstract:

This paper elucidates the channels through which sovereign risk, exchange rates and currency risk premia are related. I show that the channels are different depending on whether a country is classified as emerging or an advanced economy. Generally, for emerging market economies, local sovereign risk factors, namely country-specific political risk and macroeconomic risk do play a significant role in the depreciation of the local currency relative to the U.S. dollar. Whilst there is no convincing evidence that local determinants of sovereign risk cause a depreciation of currencies of advanced economies before the 2007 financial crisis, I do find that political risk does matter for advanced economies in the post-crisis era. For both sets of economies, global factors also play an important role in the relationship between sovereign risk and exchange rates. Secondly, double-sorting 34 currencies into different portfolios based on the level of macro risk and political risk, I provide evidence that local determinants of sovereign risk are priced in the FX markets, i.e. they can forecast currency carry trade excess returns in the cross-section. Local political risk in particular seems to have become an important carry trade risk factor in the post-2007 financial crisis era. This is the first research to explain carry trade excess returns with local sovereign risk factors as against sovereign risk as a whole.

Notable quotations from the academic research paper:

"The measure of country political risk is derived from the political risk rating of the International Country Risk Guide (ICRG). It is forward-looking and reflects political risk as opposed to an aggregate or broad measure of country risk which also incorporates macro-economic factors. While ICRG's rating is mostly subjective assessments of various country experts, there is ample evidence in the literature that it correctly reects the adverse effects of political risk on investment values across countries

The political risk rating is composed of 12 subcomponents namely: government stability, socioeconomic conditions, investment profile, internal conflict, external conflict, corruption, military in politics, religious tensions, ethnic tensions, law and order, democratic accountability and bureaucratic quality. This measure ranges from 0-100 with higher scores reflecting low level of political risk. Following (Bekaert et al., 2014), I construct country political risk as the difference of the log inverse of the ICRG rating for a country and the log inverse of the equivalent rating for the U.S.A, i.e. log(1/pr^f ) – log(1/pr^us).

I find that for emerging markets, an increasing level of political risk generally leads to a depreciation of the currency. A rising level of the other country-specific component of sovereign risk, i.e. macroeconomic risk also generally leads to a depreciation of the local currency. Of the two country-specific risks, political risk seems to have the stronger effect on currency depreciation in terms of magnitude. Whereas I find no such effect of country-specific political risk and macroeconomic risk on exchange rates for developed economies in the pre-2007 financial crisis period, I do find that political risk does matter for advanced economies post-2007 crisis. For both sets of economies, increasing global risk aversion generally leads to a depreciation of the currency under all sub-samples.

Secondly, I investigated whether our local determinants of sovereign risk have the ability to explain currency carry trade excess returns. I do find that they indeed do. Portfolios double-sorted on country-political risk and macroeconomic risk produce excess returns and slopes that increase from low political risk portfolios to high political risk portfolios under all macro risk groups in the post-2007 crisis sub-period. The argument for political risk being priced is less convincing under the pre-2007 crisis sub-sample. Instead, there is a stronger case for macro risk being priced pre-2007 financial crisis whereas the argument for macro risk is weaker post-2007 financial crisis."

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