Risk Appetite and Exchange Rates

Hyun Song Shin, Erkko Etula and Tobias Adrian

No 311, 2010 Meeting Papers from Society for Economic Dynamics

Abstract: We present evidence that the funding liquidity aggregates of U.S. financial intermediaries forecast exchange rate growth---at weekly, monthly, and quarterly horizons, both in-sample and out-of-sample, and for a large set of currencies. We estimate prices of risk using a cross-sectional asset pricing approach and show that U.S. dollar funding liquidity forecasts exchange rates because of its association with time-varying risk premia. We provide a theoretical foundation for a funding liquidity channel in an intertemporal equilibrium pricing model where the "risk appetite" of dollar-funded intermediaries fluctuates with the tightness of their balance sheet constraints. Our empirical evidence shows that this channel is separate from the more familiar "carry trade" channel.

Date: 2010
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Working Paper: Risk appetite and exchange Rates (2009)
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Persistent link: https://EconPapers.repec.org/RePEc:red:sed010:311

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