Currency Risk in the Long Run

We study the long-horizon risk profile of a currency strategy, whereby a US investor earns excess returns by entering in an unhedged long position in a foreign long-term bond funded at the domestic risk-free rate. After showing the drivers of the strategy returns, we derive and estimate their long-horizon predictive variance using data on long-term bonds denominated in major currencies over the past two centuries. We find that the long-horizon risk of such strategies increases with the investment horizon and that it is mainly driven by the uncertainty associated with the predictions of future returns originating from interest rate differentials and exchange rate returns. Currency risk, Long-term bonds, Predictability, Long-term investments