Countercyclical currency risk premia

"The average forward discount of the dollar against developed market currencies is the best predictor of average foreign currency excess returns earned by U.S. investors on a long position in a large basket of foreign currencies and a short position in the dollar. The predicted excess returns are strongly connected to the U.S. business cycle, and increase dramatically during U.S. recessions as the average forward discount increases. Adding the rate of U.S. industrial production growth as a predictor increases the predictability of foreign currency returns to 30% at the 12-month horizon. Using a no-arbitrage model of exchange rates we show that the counter-cyclical dollar risk premium reflects time-varying compensation to U.S. investors for taking on U.S. specific risk by shorting the dollar. The model implies that predictability of exchange rate changes, as opposed to excess returns, is much harder to detect in small samples, as is the case in the data"--National Bureau of Economic Research web site.