We examine the ability of existing and new factor models to explain the comovements of G10-currency changes. Extant currency factors include the carry, volatility, value, and momentum factors. Using a new clustering technique, we find a clear two-block structure in currency comovements with the first block containing mostly the dollar currencies, and the other the European currencies. A factor model incorporating this "clustering" factor and two additional factors, a commodity currency factor and a "world" factor based on trading volumes, fits all bilateral exchange rates well, whatever the currency perspective. In particular, it explains on average about 60% of currency variation and generates a root mean squared error relative to sample correlations of only 0.11. The model also explains a considerable fraction of the variation in emerging market currencies.
Aloosh, Arash, and Geert Bekaert. "Currency Factors." Management Science (forthcoming).
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