Resource title

International correlation risk

Resource image

image for OpenScout resource :: International correlation risk

Resource description

This paper focuses on correlation risk as a driver of currency returns. We illustrate that correlation risk is priced in currency markets in two ways. First, we use cross-sectional data on spot exchange rates and currency options in order to construct a correlation risk premium, defined as the difference between the risk-neutral and the objective measure exchange rate correlation, and show that it is large (15% on average) and time-varying. Second, we construct a correlation risk factor and we sort currencies into portfolios according to their conditional exposure to that factor. We find that a trading strategy that is long on low correlation beta currencies and high on low correlation beta currencies yields an annualized excess return of 4% between 1999 and 2011. We also find that high (low) interest rate currencies have negative (positive) loadings on the correlation risk factor. Given that the correlation risk factor has a negative price, engaging in the carry trade is a very risky strategy and, as a result, has a high risk pre- mium. To address our empirical findings, we consider a multi-country general equilibrium model with time-varying risk aversion generated by external habit preferences. In the model, currency risk premia mostly compensate for exposure to global risk aversion, defined as a weighted average of country risk aversions. Given countercyclical real interest rates, the model can also address the forward premium puzzle, as high interest rate currencies are very exposed to (while low interest rate currencies provide a hedge to) global risk aversion risk. We also show that high global risk aversion is associated with high conditional exchange rate variance and covariance, providing theoretical justification for sorting currencies on their exposure to fluctuations of exchange rate conditional second moments.

Resource author

Resource publisher

Resource publish date

Resource language

en

Resource content type

Resource resource URL

http://eprints.lse.ac.uk/43087/

Resource license