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An investment-based explanation of currency excess returns

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  • Jamali, Ibrahim
  • Yamani, Ehab
  • Smallwood, Aaron D.

Abstract

This paper offers an investment-based explanation for currency excess returns using fundamental macroeconomic drivers emanating from physical investment across countries. To obtain valid factors for our proposed production model, we draw on an international investment-based asset-pricing model where representative firms in two countries choose structure and equipment capital to maximize profits. We empirically test the model for the factors constructed by sorting currencies based on differences in gross fixed capital formation, and investment in equipment and structures. Our findings show that the investment risk factors are priced in the cross-section of currency excess returns. The prices of risk associated with investment are negative and significant. This indicates that the currencies of countries with a higher sensitivity to investment risk earn lower excess returns. Furthermore, we show that this investment effect is not systematically related to the forward premium effect.

Suggested Citation

  • Jamali, Ibrahim & Yamani, Ehab & Smallwood, Aaron D., 2023. "An investment-based explanation of currency excess returns," Journal of International Money and Finance, Elsevier, vol. 133(C).
    • Handle: RePEc:eee:jimfin:v:133:y:2023:i:c:s0261560623000311
    DOI: 10.1016/j.jimonfin.2023.102830
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    More about this item

    Keywords

    Carry trade; Currency excess returns; Investment-based model; Q-theory; Production-based model; Factors; Two-pass regressions; Prices of risk;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • E23 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Production

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