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
May 1, 2012
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, G13working papers series
Date posted: May 3, 2012 ; Last revised: January 7, 2013
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