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Risk Appetite and Exchange Rates

22 Pages Posted: 10 Dec 2015 Last revised: 30 Aug 2017

Tobias Adrian

International Monetary Fund

Erkko Etula

Independent

Hyun Song Shin

Bank for International Settlements

Date Written: 2015-12-01

Abstract

We present evidence that the growth of U.S.-dollar-denominated banking sector liabilities forecasts appreciations of the U.S. dollar, both in-sample and out-of-sample, against a large set of foreign currencies. We provide a theoretical foundation for a funding liquidity channel in a global banking model where exchange rates fluctuate as a function of banks’ balance sheet capacity. We estimate prices of risk using a cross-sectional asset pricing approach and show that the 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. Although the financial crisis of 2007-09 induced a structural shift in our forecasting variables, when we control for this shift, the forecasting relationship is preserved.

Keywords: asset pricing, financial intermediaries, exchange rates

JEL Classification: F30, F31, G12, G24

Suggested Citation

Adrian, Tobias and Etula, Erkko and Shin, Hyun Song, Risk Appetite and Exchange Rates (2015-12-01). FRB of NY Staff Report No. 750. Available at SSRN: https://ssrn.com/abstract=2701189

Tobias Adrian (Contact Author)

International Monetary Fund ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

HOME PAGE: http://www.tobiasadrian.com

Erkko Etula

Independent ( email )

No Address Available

Hyun Song Shin

Bank for International Settlements ( email )

Centralbahnplatz 2
Basel, Basel-Stadt 4002
Switzerland

HOME PAGE: http://www.bis.org/author/hyun_song_shin.htm

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