The role of emerging markets

(with Magnus Dahlquist and Lars Lochstoer)

How do emerging economies contribute to the currency market’s conditional risk- return trade-off? We construct an out-of-sample mean-variance efficient portfolio from the G10 and floating-regime emerging-market currencies that prices trading strategies based on all available currencies and characterizes risk premiums at each date in the sample. The risk premium dynamics are consistent with both the substantial decline in average returns to many of the G10 trading strategies over the sample, and the continued high carry returns of the emerging trading strategies. Further, the approach provides a conditional return decomposition into priced and unpriced components. We show that trading strategies, including Dollar and Carry, are strongly exposed to currency factors that increase return variance, but that do not command a risk premium. This unpriced risk must be hedged out from these strategies if they are to properly characterize risk and return in the currency market. For instance, the carry strategy has a Sharpe ratio of 0.71 that increases to 1.28 after real-time hedging of unpriced risks. We relate these unpriced risks to currency comovements arising from geographically-based factors.