Global Political Risk and Currency Momentum

Abstract

Using a measure of political risk, relative to the United States, that captures unexpected political conditions, we show that political risk is priced in the cross section of currency momentum and contains information beyond other risk factors. Our results are robust after controlling for transaction costs, reversals, and alternative limits to arbitrage. The global political environment affects the profitability of the momentum strategy in the foreign exchange market; investors following such strategies are compensated for the exposure to the global political risk of those currencies they hold, that is, the past winners, and exploit the lower returns of loser portfolios. The risk compensation is mainly justified by the different exposures of foreign currencies in the momentum portfolio to U.S. political shocks, which is the main component of global political risk.