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International Correlation RiskPhilippe MuellerLondon School of Economics & Political Science (LSE) - Department of Finance Andreas StathopoulosUniversity of Southern California - Marshall School of Business Andrea VedolinLondon School of Economics and Political Science May 1, 2012 Abstract: We provide novel evidence of priced correlation risk in the foreign exchange market. Currencies that perform badly (well) during periods of high exchange rate correlation have high (low) average returns. We also show that high (low) interest rate currencies have high (low) correlation risk exposure, providing a risk-based justification for the carry trade. To address our empirical findings, we consider a general equilibrium model that incorporates preferences characterized by external habit formation and home bias. In our model, currencies which depreciate when conditional exchange rate correlation is high command high risk premia due to their adverse exposure to global risk aversion shocks.
Number of Pages in PDF File: 61 Keywords: Carry Trade, Correlation Risk, Habit, International Finance, Exchange Rates JEL Classification: F31, G12, G13 working papers seriesDate posted: May 3, 2012 ; Last revised: January 7, 2013Suggested CitationContact Information
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