The Peso Perspective: Understanding Risk and Return in Global Currency Markets

Abstract

The drivers of currency excess returns remain poorly understood despite the foreign exchange market’s size and liquidity. Using five measures of risk — novel text-based measures (from newspaper articles and firm earnings calls) alongside traditional risk indices that capture a country’s economic, financial, and political risk — I show that financial risk is the dominant predictor of volatility in emerging market currency returns, while geopolitical risk is positively associated with excess returns, supporting a risk premium explanation for the profitability of currency trades. Firm-level risk perceptions, especially from foreign firms, outperform political/economic risk in forecasting returns. However, country-specific risks explain only a fraction of exchange rate movements, revealing fundamental limits to forecasting exchange rate movements. The results highlight financial stability as a stronger determinant of risk premia than political uncertainty, with implications for currency speculators and policy-making in emerging economies.