Intermediary Leverage and the Currency Risk Premium

Abstract

I study how the cross-country intermediary heterogeneity drives currency risks and returns. I build a
model in which intermediaries lever up and hold interest-free cash for liquidity. Liquidity is cheap in low-interest-rate countries, and intermediaries take on high leverage. Hence, intermediaries’ wealth declines sharply following a negative shock. Portfolio rebalancing toward domestic assets makes low-interest-rate currencies appreciate in bad times and require low returns. I validate the model implied relations among interest rate, bank leverage, portfolio rebalancing, exchange rate changes, and currency risk premia in the data.

Keywords: Liquidity, Interest rate, Intermediary leverage, Currency risk premium

JEL Classification: E40, F31, G15, G21