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Pricing Implications of Covariances and Spreads in Currency Markets

The Review of Asset Pricing Studies 2022 12(1), 336-388
We introduce a covariance and spread (i.e., exchange rate forward discount) adjusted carry factor that prices the cross-section of FX market returns, where many other single- and multifactor models fail. Both the covariance matrix of exchange rate growths and forward discounts contain important information for pricing that is not captured by well-known factors. The time-varying conditional covariance matrix and forward discounts forecast future realized currency returns.