Risk Appetite and Exchange Rates
45 Pages Posted: 5 Feb 2009 Last revised: 29 Mar 2018
Date Written: May 2010
We present evidence that the funding liquidity aggregates of U.S. financial intermediaries forecast U.S. dollar exchange rate growth—at weekly, monthly, and quarterly horizons, both in-sample and out-of-sample, and against a large set of foreign currencies. We provide a theoretical foundation for a funding liquidity channel in a simple asset pricing model where the effective risk aversion of dollar-funded intermediaries fluctuates with the tightness of their risk constraints. We estimate prices of risk using a cross-sectional asset pricing approach and show that U.S. dollar funding liquidity forecasts exchange rates because of its association with time-varying risk premia. Our empirical evidence shows that this channel is separate from the more familiar “carry trade” channel.
Keywords: asset pricing, financial intermediaries, exchange rates
JEL Classification: F30, F31, G12, G24
Suggested Citation: Suggested Citation