A new paper supports the view that currency excess returns can to some extent be viewed as compensation for risk to net capital flows in imperfect markets. An increase in current account uncertainty can be approximated by economists’ forecast dispersion. Historically, a rise in current account uncertainty has reduced returns on carry currencies and investment currencies, i.e. those of countries with net capital inflows. There is also evidence that markets have been sluggish in adapting to higher uncertainty.

Pasquale Della Corte, Aleksejs Krecetovs (2017), “Macro Uncertainty and Currency Premia”, available at SSRN.

The below are excerpts from the paper. Headings, links and cursive text have been added.

The impact of uncertainty

“A number of studies suggest that foreign exchange investors are compensated for bearing global risk. Our paper…provides novel evidence on the link between currency excess returns and measures of economic [uncertainty]…quantified by the dispersion of market participants’ macro forecasts.”

“We find evidence that investment currencies deliver low returns whereas funding currencies offer a hedge when current account uncertainty is unexpectedly high…Moreover, an increase in current account uncertainty leads to deteriorating investment opportunities through lower expected returns on carry and global imbalance strategies…Higher current account uncertainty is associated with lower expected returns on these strategies. This holds even after controlling for variables such as volatility and liquidity.”

“Our results support…exchange rate determination based on capital flows with imperfect financial markets. Overall, we show that currency excess returns can be rationalized as compensation for unexpected shocks to current account uncertainty…An increase in the uncertainty about future trade imbalances corresponds to tighter financial conditions.”

“Recent literature suggests that higher information uncertainty leads to higher expected returns following good news and lower expected returns following bad news. This happens as information is slowly incorporated into prices. Zhang (2006) investigates this hypothesis using price momentum to distinguish good news from bad news, and a number of indicators such as dispersion in analyst earnings forecasts and stock market volatility to proxy for information uncertainty. Ultimately, greater information uncertainty should predict relatively lower future returns for past losers and relatively higher future returns for past winners…He finds that the profitability of the momentum strategy that buys past winners and sells past losers is enhanced in periods of high uncertainty as opposed to periods of low uncertainty.”

How to measure uncertainty

“Our study is also closely related to a growing literature on the link between macro uncertainty and asset returns whereby forecast dispersion is regarded as a model-free measure of uncertainty.”

“Using a unique dataset of agents’ expectations from the two independent surveys of international macro forecasts, we construct cross-sectional forecast dispersions on current account, short-term interest rate, inflation rate, real economic growth and foreign exchange rate which we interpret as proxies of macro uncertainty.”

“We have assembled a unique dataset of monthly forecasts running from July 1993 to July 2013 on five international economic indicators and prices: current account (ca), inflation rate (if), short-term interest rate (ir), real economic growth (rg), and foreign exchange rate (fx). We have obtained these forecasts from two distinct surveys of market participants’ expectations, namely Blue Chip Economic Indicators published by Aspen Publishers and Consensus Forecasts compiled by Consensus Economics.”

“Armed with these data, we first construct for each macro variable country-level forecast dispersions, and then take the cross-country average to determine their systematic, or global, component.”

“We study the interaction between price momentum and information uncertainty in foreign exchange markets….Each month, we sort currencies into three baskets…For each basket, we then sort currencies into two groups by means of information uncertainty level. To proxy for information uncertainty, we use country-specific measures of forecast dispersion on current account, inflation rate, short-term interest rate, real economic growth and foreign exchange rate…As additional measures of information uncertainty, we also use 1-month foreign exchange implied volatilities from at-the-money currency options traded over-the-counter.”

The link to liquidity

A considerable amount of the recent literature investigates the link between uncertainty and market liquidity. Routledge and Zin (2009) and Easley and O’Hara (2010), for instance, show in theory that market liquidity (and in turn trading activity) dries up when traders face periods of high uncertainty as in the recent 2007-2009 financial crisis. Battalio and Schultz (2011) examine the September 2008 short sale restrictions and find empirically a negative relationship between regulatory uncertainty and market liquidity in the equity options market. More recently, Chung and Chuwonganant (2014) provide evidence that aggregate market uncertainty, proxied by the VIX, explains the dynamics of market liquidity of individual stocks.


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Saeed Amen is the founder of Cuemacro. He has a decade of experience creating and successfully running systematic trading models at Lehman Brothers, Nomura, the Thalesians and now at Cuemacro. Independently, he runs a systematic trading model with proprietary capital. He is the author of Trading Thalesians – What the ancient world can teach us about trading today (Palgrave Macmillan). He graduated with a first class honours master’s degree from Imperial College in Mathematics & Computer Science. He is also the co-founder of the Thalesians.