International Correlation Risk
London School of Economics & Political Science (LSE) - Department of Finance
University of Washington
London School of Economics and Political Science
August 22, 2016
We document that cross-sectional FX correlation dispersion is countercyclical, as FX pairs with high average correlation become more correlated in bad times whereas pairs with low average correlation become less correlated. We also show that currencies that perform badly (well) during periods of high cross-sectional disparity in conditional FX correlation yield high (low) average excess returns. Finally, we find a negative cross-sectional relationship between average FX correlations and average option-implied FX correlation risk premiums. Our findings show that while spot currency markets suggest that U.S. investors require an FX risk premium for being exposed to states in which the cross section of FX correlations widens, FX options prices are consistent with U.S. investors being compensated for exposure to states that feature a tightening of the cross section of FX correlations. To jointly match the empirical properties of FX correlations and correlation risk premiums, we propose a no-arbitrage model that features unspanned FX correlation risk.
Number of Pages in PDF File: 75
Keywords: Correlation Risk, International Finance, Exchange Rates
JEL Classification: G15, F31
Date posted: May 3, 2012 ; Last revised: August 23, 2016
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