An investment-based explanation of currency excess returns

Abstract

This paper offers an investment-based explanation for currency excess returns using fundamental macroeconomic drivers emanating from physical investment across countries. To obtain valid factors for our proposed production model, we draw on an international investment-based asset-pricing model where representative firms in two countries choose structure and equipment capital to maximize profits. We empirically test the model for the factors constructed by sorting currencies based on differences in gross fixed capital formation, and investment in equipment and structures. Our findings show that the investment risk factors are priced in the cross-section of currency excess returns. The prices of risk associated with investment are negative and significant. This indicates that the currencies of countries with a higher sensitivity to investment risk earn lower excess returns. Furthermore, we show that this investment effect is not systematically related to the forward premium effect. © 2023 Elsevier Ltd