Currency Exposure to Downside Risk: Which Fundamentals Matter?

Abstract

I study whether or not countries’ macroeconomic characteristics are systematically related to their currencies' exposure to the downside market risk. I find that currency downside risk is strongly associated with the local inflation rate, real interest rate and net foreign asset position. Currencies of countries with higher inflation and real interest rates and lower (negative) net foreign asset position (debtor countries) are more exposed to the downside risk whereas currencies of countries with low inflation and real interest rates and positive net foreign asset position (creditor countries) exhibit ‘safe haven’ properties. The local real interest rate has the highest explanatory power in accounting for the cross-section of currency exposure to the downside risk. This suggests that the high currency downside risk is a consequence of investments in high-yield risky currencies and flight from them in ‘hard times’. Currency exposure to the downside market risk has increased significantly in the 2000s when the volume of currency trading by institutional investors increased.

Keywords: currency risk, downside risk, downside beta, carry trades

JEL Classification: G11, G15, F31