Intermediary Leverage and Currency Risk Premium

64 Pages Posted: 9 Dec 2018

See all articles by Xiang Fang

Xiang Fang

University of Pennsylvania, School of Arts & Sciences, Department of Economics

Date Written: November 25, 2018

Abstract

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

Fang, Xiang, Intermediary Leverage and Currency Risk Premium (November 25, 2018). Available at SSRN: https://ssrn.com/abstract=3290317 or http://dx.doi.org/10.2139/ssrn.3290317

Xiang Fang (Contact Author)

University of Pennsylvania, School of Arts & Sciences, Department of Economics ( email )

Suite 150
133 South, 36 Street
Philadelphia, PA 19104
United States

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