The Cross-Section of Foreign Currency Risk Premia and Consumption Growth Risk

Aggregate consumption growth risk explains why low interest rate curren- cies do not appreciate as much as the interest rate di®erential and why high interest rate currencies do not depreciate as much as the interest rate di®er- ential. Domestic investors earn negative excess returns on low interest rate currency portfolios and positive excess returns on high interest rate currency portfolios. Because high interest rate currencies depreciate on average when domestic consumption growth is low and low interest rate currencies appreci- ate under the same conditions, low interest rate currencies provide domestic investors with a hedge against domestic aggregate consumption growth risk.