A “Bad Beta, Good Beta” Anatomy of Currency Risk Premiums and Trading Strategies

Abstract The paper introduces a novel two-beta currency pricing model, which decomposes the conventional dollar factor beta into a beta with risk-premium news and a beta with real-interest-rate news. These betas capture distinct features of currency returns and explain cross-sectional variations in currency risk premiums. The risk-premium beta is associated with an unconditionally positive price of risk, while the real-rate beta has an unconditionally negative price of risk due to precautionary savings. The prices of these beta risks exhibit conditional variations tied to economic conditions. Furthermore, the model explains the abnormal performance of various currency trading strategies.