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International Correlation RiskPhilippe MuellerLondon School of Economics & Political Science (LSE) - Department of Finance Andreas StathopoulosUniversity of Washington Andrea VedolinLondon School of Economics and Political Science October 26, 2016 Abstract: We document that the cross-sectional dispersion of conditional FX correlation is countercyclical and that currencies that perform badly (well) during periods of high dispersion yield high (low) average excess returns. We also find a negative cross-sectional association between average FX correlations and average option-implied FX correlation risk premiums. Our findings show that while investors in spot currency markets require a positive risk premium for exposure to high-dispersion states, FX option prices are consistent with investors being compensated for the risk of low-dispersion states. To address our empirical findings, we propose a no-arbitrage model that features unspanned FX correlation risk.
Number of Pages in PDF File: 70 Keywords: Correlation Risk, Exchange Rates, International Finance JEL Classification: F31, G15 Date posted: May 3, 2012 ; Last revised: October 29, 2016Suggested CitationContact Information
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