International Correlation Risk
London School of Economics & Political Science (LSE) - Department of Finance
University of Southern California - Marshall School of Business
London School of Economics and Political Science
November 10, 2014
We document that cross-sectional FX correlation disparity is countercyclical, as exchange rate pairs with high average correlation become more correlated in bad times whereas pairs with low average correlation become less correlated. We show that currencies that perform badly (well) during periods of high cross-sectional disparity in conditional FX correlation yield high (low) average excess returns, suggesting that correlation risk is priced in currency markets. Furthermore, we find a negative cross-sectional relationship be- tween average FX correlations and average FX correlation risk premia. Finally, we propose a no-arbitrage model that can match salient properties of FX correlations and correlation risk premia.
Number of Pages in PDF File: 68
Keywords: Correlation Risk, International Finance, Exchange Rates
JEL Classification: F31, G12, G13
Date posted: May 3, 2012 ; Last revised: November 11, 2014
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