Intermediary Leverage and Currency Risk Premium
64 Pages Posted: 9 Dec 2018
Date Written: November 25, 2018
This paper proposes an intermediary-based explanation of the risk premium of currency carry trade in a model with a cross-section of small open economies. In the model, bankers in each country lever up and hold interest-free cash as liquid assets against funding shocks. Countries set different nominal interest rates, while low interest rates encourage bankers to take high leverage. Consequently, bankers' wealth drops sharply with a negative shock. This reduces foreign asset demand and leads to a domestic appreciation, which in turn makes low-interest-rate currencies good hedges. The model implies covered interest rate parity deviations when safe assets differ in liquidity. The empirical evidence is consistent with the main model implications: (i) Low-interest-rate countries have high bank leverage and low currency returns; (ii) the carry trade return is procyclical with a positive exposure to the bank stock return; and (iii) comovement of the carry trade return and the stock return increases with the stock market volatility.
Keywords: Bank Leverage, Carry Trade, Currency Risk Premium, Exchange Rate, Liquidity Premium, Nominal Interest Rate
JEL Classification: E40, F31, G15, G21
Suggested Citation: Suggested Citation