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International correlation risk

Philippe Mueller, Andreas Stathopoulos and Andrea Vedolin

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

Abstract: We provide novel evidence of priced correlation risk in the foreign exchange market. Currencies that perform badly (well) during periods of high exchange rate correlation have high (low) average returns. We also show that high (low) interest rate currencies have high (low) correlation risk exposure, providing a risk-based justification for the carry trade. To address our empirical findings, we consider a general equilibrium model that incorporates preferences characterized by external habit formation and home bias. In our model, currencies which depreciate when conditional exchange rate correlation is high command high risk premia due to their adverse exposure to global risk aversion shocks.

Keywords: carry trade; correlation risk; habit; international finance; exchange rates (search for similar items in EconPapers)
JEL-codes: F31 G12 G15 (search for similar items in EconPapers)
Pages: 52 pages
Date: 2013-01-01
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

Downloads: (external link)
http://eprints.lse.ac.uk/43087/ Open access version. (application/pdf)

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