Systematic Consumption Risk in Currency Returns

Sorting currencies on past consumption growth is equivalent to sorting them on interest rates: during normal times, high past-consumption-growth currencies appreciate more (depreciate less) than uncovered interest parity would imply. This is a risk premium because these currencies also depreciate strongly during global shocks. We explain our findings in a quantitative model of habit formation in consumption: countries with high past consumption growth have low risk aversion (i.e. a high risk absorption capacity) and high interest rates. Efficient risk sharing implies that countries with lower risk aversion bear larger drops in consumption in globally bad times. This is achieved through a depreciation of these currencies, which effectively transfers purchasing power to countries with low risk bearing capacity.