Political risks, excess and carry trade returns in global markets

We re-examine the relationship between exchange rates and sovereign risk and provide evidence that sovereign risk affects advanced economies and emerging markets differently. Also, double-sorting 34 currencies from developed and emerging economies into different portfolios based on the level of macro risk and political risk, we provide evidence that local determinants of sovereign risk are priced in the FX markets. Local political risk in particular seems to have become an important carry trade risk factor in the post-2007 financial crisis era. High macro risk portfolios in the presence of high political risk lead to higher excess returns. Our results are robust across country categories and currency regimes, with stronger results for emerging economies. This is one of the few papers to examine how the local components of sovereign risk, rather than the systematic risk component, drive currency carry trade returns. We contribute a fresh perspective that supports the risk-based view on the UIP puzzle.