Currency Risk and Central Banks
41 Pages Posted: 15 Oct 2018
Date Written: October 8, 2018
The correlation of currency carry returns with global equity markets increased sharply after the recent financial crisis. Popular carry trades returned an average 4 percent per year both before and after the crisis, yet these strategies were uncorrelated with equity returns prior to 2008. To rationalize this change, we develop a simple model in which central banks adjust interest rate spreads to absorb changes in currency risk. Before the financial crisis, time variation in spreads dampened the co-movement of currencies and equity markets. Afterward, as the zero lower bound and macroeconomic concerns constrained central bank policy, the correlation increased. We document changes in the relationship of both interest rate spreads and foreign exchange rates with equity markets which are consistent with this framework.
Keywords: foreign exchange, central banks, carry trade, risk premia
JEL Classification: E44, E58, F31, G15
Suggested Citation: Suggested Citation