The Conditional Dollar-Carry FX Pricing Model

We introduce a novel GMM estimation procedure to assess conditional factor models without the need to specify a set of conditioning variables. The conditional Dollar-Carry (DOL-CAR) two factor pricing model is able to explain a rich cross-section of average currency returns. It is important to account for the time-variation in the conditional moments when estimating FX factor models. Unconditional estimations which ignore this time-variation mistakenly reject the DOL-CAR two factor model. Our results imply that there is predictability in factor returns. We estimate lower bounds for the predictive regression R2 of 6.69% for DOL and 4.06% for CAR