Currency Risk and Central Banks

41 Pages Posted: 15 Oct 2018

See all articles by Andrew Lilley

Andrew Lilley

Harvard University, Department of Economics

Gianluca Rinaldi

Harvard University, Department of Economics

Date Written: October 8, 2018

Abstract

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

Lilley, Andrew and Rinaldi, Gianluca, Currency Risk and Central Banks (October 8, 2018). Available at SSRN: https://ssrn.com/abstract=3262313 or http://dx.doi.org/10.2139/ssrn.3262313

Andrew Lilley

Harvard University, Department of Economics ( email )

Cambridge, MA
United States

HOME PAGE: http://https://scholar.harvard.edu/andrewlilley

Gianluca Rinaldi (Contact Author)

Harvard University, Department of Economics ( email )

Cambridge, MA
United States

HOME PAGE: http://scholar.harvard.edu/rinaldi

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