Risk appetite and exchange Rates

Tobias Adrian, Erkko Etula and Hyun Song Shin

No 361, Staff Reports from Federal Reserve Bank of New York

Abstract: We present evidence that the growth of U.S.-dollar-denominated banking sector liabilities forecasts appreciations of the U.S. dollar, both in-sample and out-of-sample, against a large set of foreign currencies. We provide a theoretical foundation for a funding liquidity channel in a global banking model where exchange rates fluctuate as a function of banks? balance sheet capacity. We estimate prices of risk using a cross-sectional asset pricing approach and show that the U.S. dollar funding liquidity forecasts exchange rates because of its association with time-varying risk premia. Our empirical evidence shows that this channel is separate from the more familiar ?carry trade? channel. Although the financial crisis of 2007-09 induced a structural shift in our forecasting variables, when we control for this shift, the forecasting relationship is preserved.

Keywords: asset pricing; financial intermediaries; exchange rates (search for similar items in EconPapers)
JEL-codes: F30 F31 G12 G24 (search for similar items in EconPapers)
Date: 2009
New Economics Papers: this item is included in nep-cba, nep-ifn and nep-opm
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Citations: View citations in EconPapers (4)

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Working Paper: Risk Appetite and Exchange Rates (2010)
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