Common Factors in Currency Characteristics

Abstract: We study the factor structure of currency characteristics using a tensor factor model that jointly captures variation across currencies, characteristics, and time. The resulting compressed characteristics factors (CCF) outperform standard currency factors in pricing a broad cross-section of currency portfolios as well as formal spanning tests. The first CCF resembles carry trades while the second is a time-varying value-momentum spread factor that helps reconcile differing conclusions on factors beyond dollar and carry. This factor generates large positive returns during carry-crash episodes via positions outside of crowded trades, consistent with the sudden unwinding of speculative positions due to constrained intermediary capital.