This paper identifies a "slope" factor in exchange rates, which explains most of the cross-sectional variation in average excess returns between high and low interest rate currencies. The slope factor accounts for the co-movement among exchange rates of different currencies and is related to changes in global equity market volatility. The authors show that a no-arbitrage model of interest rates with two factors – a country-specific factor and a global factor – can replicate these findings, provided there is sufficient heterogeneity in exposure to global or common innovations. The slope factor is very similar to the return on a zero-cost strategy that goes long in the last portfolio and short in the first portfolio. This factor is labeled as the carry trade risk factor $ HML_{FX} $, for high minus low interest rate currencies. The paper is the first to document the common factor in exchange rates sorted by interest rates, which is the key ingredient in a risk-based explanation of carry trade returns. The authors use monthly currency portfolios sorted by forward discounts to identify the slope factor. The first portfolio contains the lowest interest rate currencies, while the last contains the highest. The first two principal components of the currency portfolio returns account for most of the time series variation in currency returns. The first principal component is a level factor, and the second is a slope factor. The slope factor is closely related to changes in global equity market volatility. The authors show that the slope factor identifies these common shocks and that it is related to changes in global equity market volatility. The paper also shows that the slope factor is a key ingredient in a risk-based explanation of carry trade returns. The authors use a no-arbitrage model of exchange rates to interpret these findings. A calibrated version of the model replicates the key moments of the data. The paper also shows that an equity-based volatility measure accounts for the cross-section of carry trade returns, as predicted by the model. High (low) interest rate currencies tend to depreciate (appreciate) when global equity volatility is high. The paper also shows that the slope factor is a key ingredient in a risk-based explanation of carry trade returns. The authors find that the slope factor is closely related to changes in global equity market volatility. The paper also shows that the slope factor is a key ingredient in a risk-based explanation of carry trade returns. The authors find that the slope factor is closely related to changes in global equity market volatility. The paper also shows that the slope factor is a key ingredient in a risk-based explanation of carry trade returns.This paper identifies a "slope" factor in exchange rates, which explains most of the cross-sectional variation in average excess returns between high and low interest rate currencies. The slope factor accounts for the co-movement among exchange rates of different currencies and is related to changes in global equity market volatility. The authors show that a no-arbitrage model of interest rates with two factors – a country-specific factor and a global factor – can replicate these findings, provided there is sufficient heterogeneity in exposure to global or common innovations. The slope factor is very similar to the return on a zero-cost strategy that goes long in the last portfolio and short in the first portfolio. This factor is labeled as the carry trade risk factor $ HML_{FX} $, for high minus low interest rate currencies. The paper is the first to document the common factor in exchange rates sorted by interest rates, which is the key ingredient in a risk-based explanation of carry trade returns. The authors use monthly currency portfolios sorted by forward discounts to identify the slope factor. The first portfolio contains the lowest interest rate currencies, while the last contains the highest. The first two principal components of the currency portfolio returns account for most of the time series variation in currency returns. The first principal component is a level factor, and the second is a slope factor. The slope factor is closely related to changes in global equity market volatility. The authors show that the slope factor identifies these common shocks and that it is related to changes in global equity market volatility. The paper also shows that the slope factor is a key ingredient in a risk-based explanation of carry trade returns. The authors use a no-arbitrage model of exchange rates to interpret these findings. A calibrated version of the model replicates the key moments of the data. The paper also shows that an equity-based volatility measure accounts for the cross-section of carry trade returns, as predicted by the model. High (low) interest rate currencies tend to depreciate (appreciate) when global equity volatility is high. The paper also shows that the slope factor is a key ingredient in a risk-based explanation of carry trade returns. The authors find that the slope factor is closely related to changes in global equity market volatility. The paper also shows that the slope factor is a key ingredient in a risk-based explanation of carry trade returns. The authors find that the slope factor is closely related to changes in global equity market volatility. The paper also shows that the slope factor is a key ingredient in a risk-based explanation of carry trade returns.