I quantify the risk-return relationship in the foreign exchange market in the cross-section and across investment horizons by focusing on the role of multiple sources of US consumption risk. To this end, I estimate a flexible structural model of the joint dynamics of aggregate consumption, inflation, nominal interest rate, and stochastic variance with cross-equation restrictions implied by recursive preferences. I identify the following four structural shocks: inflation, short-run, long-run and variance consumption risks. To measure their relative importance, I compute marginal quantities and prices of risk (marginal Sharpe ratios) in the cross-section of currency baskets for alternative investment horizons. I find that the long-run consumption risk plays a prominent role: it carries an average quarterly Sharpe ratio of 0.28 and contributes to the spread in excess returns between baskets of high and low interest rate currencies across investment horizons from one to five quarters. The short-run consumption risk has an effect on currencies at the horizon of one quarter only, where it explains at least 40% of the corresponding spread in excess returns. The carry trade profitability disappears at horizons longer than four quarters.

I relate the downward‐sloping term structure of currency carry returns to compensation for currency exposures to macroeconomic risk embedded in the joint dynamics of U.S. consumption, inflation, nominal interest rate, and their stochastic variance. The interest rate and inflation shocks play a prominent role. Higher yield currencies exhibit higher multiperiod exposures to these shocks. The prices of these risk exposures are positive and sizeable across all investment horizons. The interest rate shock is qualitatively similar to the long‐run risk of Bansal and Yaron.

We develop an empirical model of bilateral exchange rates. It includes normal shocks with stochastic variance and jumps in an exchange rate and in its variance. The probability of a jump in an exchange rate corresponding to depreciation (appreciation) of the U.S. dollar is increasing in the domestic (foreign) interest rate. The probability of a jump in variance is increasing in the variance only. Jumps in exchange rates are associated with announcements; jumps in variance are not. On average, jumps account for 25% of currency risk. The dollar carry index retains these features. Options suggest that jump risk is priced.

Long-run asset pricing restrictions in a macro term structure model identify discretionary monetary policy separately from a policy rule. We find that policy discretion is an important contributor to aggregate risk. In addition, discretionary easing coincides with good news about the macroeconomy in the form of lower inflation, higher output growth, and lower risk premiums on short-term nominal bonds. However, it also coincides with bad news about long-term financial conditions in the form of higher risk premiums on long-term nominal bonds. Shocks to the rule correlate with changes in the yield curve’s level. Shocks to discretion correlate with changes in its slope.