International Correlation Risk
London School of Economics & Political Science (LSE) - Department of Finance
University of Washington
London School of Economics and Political Science
January 26, 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, and 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 between average FX correlations and average option-implied FX correlation risk premia. To jointly match the properties of FX correlations and correlation risk premia, we propose a no-arbitrage model that features unspanned FX correlation risk.
Number of Pages in PDF File: 73
Keywords: Correlation Risk, International Finance, Exchange Rates
JEL Classification: G15, F31
Date posted: May 3, 2012 ; Last revised: January 26, 2016
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