Dominant Currency Pricing and Currency Risk Premia

IMF Working Papers, July 31, 2026

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This paper studies how dominant-currency pricing affects currency risk premia.
Empirically, common risk factors are extracted from excess currency returns using principal components.
Countries’ factor exposures are related to observable macroeconomic characteristics, with export dollar invoicing emerging as a predictor of carry trade exposure.
A small open-economy model with dominant-currency pricing and dollar-denominated liabilities is used to explain the empirical results.
Key mechanism: dollar export invoicing weakens the exchange rate's stabilizing effect on external demand; dollar debt makes depreciation costly for leveraged intermediaries. When both frictions interact:
- Depreciations occur in bad states.
- Local-currency assets become risky.
- The currency premium rises.
- The risk-adjusted neutral rate increases.
- Under a standard Taylor rule, this mechanism generates persistently higher inflation.

Method: Principal components extraction of common risk factors from excess currency returns.
Main empirical predictor identified: export dollar invoicing predicts carry trade exposure.
Relationship established between countries’ factor exposures and observable macroeconomic characteristics (export dollar invoicing highlighted).

Model features: small open-economy with dominant-currency pricing and dollar-denominated liabilities.
Mechanisms described:
- Dollar export invoicing reduces the exchange rate’s effectiveness in stabilizing external demand.
- Dollar-denominated liabilities (dollar debt) make depreciation costly for leveraged financial intermediaries.
- Interaction of these frictions causes depreciations to coincide with bad states, elevating risk in local-currency assets and increasing currency premia and the risk-adjusted neutral rate.
- Under a standard Taylor rule, these dynamics lead to persistently higher inflation.

Sources of elevated currency risk premia include export dollar invoicing and dollar-denominated liabilities.
Interactions between pricing currency and liability currency can amplify macroeconomic volatility and inflation persistence via higher currency premia and a higher risk-adjusted neutral rate.
Insights relevant for policymakers concerned with exchange-rate exposure, debt currency composition, and inflation dynamics under standard monetary policy rules.