Risk Appetite and Exchange Rates
Federal Reserve Bank of New York
affiliation not provided to SSRN
Hyun Song Shin
Princeton University - Department of Economics
FRB of New York Staff Report No. 361
We present evidence that the funding liquidity aggregates of U.S. financial intermediaries forecast U.S. dollar exchange rate growth—at weekly, monthly, and quarterly horizons, both in-sample and out-of-sample, and against a large set of foreign currencies. We provide a theoretical foundation for a funding liquidity channel in a simple asset pricing model where the effective risk aversion of dollar-funded intermediaries fluctuates with the tightness of their risk constraints. 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. Our empirical evidence shows that this channel is separate from the more familiar “carry trade” channel.
Number of Pages in PDF File: 45
Keywords: asset pricing, financial intermediaries, exchange rates
JEL Classification: F30, F31, G12, G24working papers series
Date posted: February 5, 2009 ; Last revised: November 10, 2010
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