37 Pages Posted: 10 Dec 2015
Date Written: 2015-12-01
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: 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