The sources of pricing factors underlying the cross-section of currency returns

We propose four factors, including carry, momentum, value as well as currency market risk factors in a risk-based asset pricing framework. By examining currency portfolios through time series and cross-sectional asset pricing, we validate that the four-factor model is capable of capturing the excess returns to these portfolios. Next, to understand the economic forces behind the carry, momentum and value factors, we investigate the linkages of these three factors to several fundamental variables. Our results indicate that the carry factor is linked to innovations in equity volatility and liquidity risk, whilst the momentum one is linked to innovations in equity volatility, funding liquidity risk and lagged short rate, whereas the value factor is linked to innovations in equity volatility, lagged term spread and lagged default spread. Whilst investors require compensation for a carry strategy that performs poorly when global market conditions deteriorate, they will pay for a momentum strategy that performs well under these circumstances. Positive innovations in equity volatility, an increase in funding liquidity risk and lagged short rate are good proxies for such periods.