International Finance and Exchange Rates

Paper Session

Friday, Jan. 6, 2017 10:15 AM – 12:15 PM

Sheraton Grand Chicago, Chicago Ballroom VIII
Hosted By: American Finance Association
  • Chair: Hanno Lustig, Stanford University

The Cross-Section of Currency Volatility Premia

Pasquale Della Corte
Imperial College London
Roman Kozhan
University of Warwick
Anthony Neuberger
Cass Business School


We identify a global risk factor that drives the cross-section of volatility excess returns in the foreign exchange market. We show that a zero-cost strategy that buys forward volatility agreements with downward sloping volatility curves and sells those with upward slopes – the volatility carry strategy – earns on average 5.15% per month. When we form slope-sorted portfolios, the covariation with volatility carry returns fully explains the cross-sectional variation of our portfolios. The lower the slope of the volatility curve, the more the forward volatility agreement is exposed to volatility carry risk. A standard no-arbitrage model of exchange rates with two types of factor – a set of country specific factors and a global one – provides intuition for the findings. The state variables determining the exposure to the global risk factor are empirically related to squared deviations of changes in economic growth. In the cross-section, the returns to volatility carry strategy are only weakly related to traditional currency risk factors, like carry, global imbalance, global volatility and global liquidity risk.

Real Exchange Rates and Currency Risk Premia

Pierluigi Balduzzi
Boston College
I-Hsuan Ethan Chiang
University of North Carolina-Charlotte


We exploit the link between deviations from uncovered interest rate parity (UIP), long-run relative purchasing power parity (PPP), and deviations from real rate equality, to develop more powerful tests of the predictive power of real exchange rates for excess currency returns. Assuming long-run relative
PPP, we obtain much stronger evidence of predictability than if we test UIP in isolation. The real exchange rate is also the main driver of long-horizon UIP deviations and a dominant fraction of the real exchange rate variance is due to UIP deviations. Modified versions of the "habit" and "long-run risks" models qualitatively replicate these findings.

Uncertainty, the Exchange Rate and International Capital Flows

Robert Kollmann
ECARES, Free University of Brussels, and CEPR


This paper analyzes the effects of output volatility shocks and of risk appetite shocks on
the dynamics of the real exchange rate, consumption and net foreign assets, in a two country
world with recursive preferences and complete financial markets. When the risk aversion coefficient exceeds the inverse of the intertemporal substitution elasticity, then an exogenous rise in a country’s output volatility triggers a wealth transfer to that country, in equilibrium; this raises its consumption, lowers its trade balance and appreciates its real exchange rate. The effects of risk appetite shocks resemble those of volatility shocks. In a recursive preferences-complete markets framework, volatility and risk appetite shocks account for a noticeable share of the fluctuations of the real exchange rate, net exports and net foreign assets. These shocks help to explain the high empirical volatility of the real exchange rate and the disconnect between relative consumption growth and the real exchange rate.

Entangled Risks in Incomplete FX Markets

Thomas Maurer
Washington University-St. Louis
Ngoc-Khanh Tran
Washington University-St. Louis


We study the implications of risk entanglements on international financial (FX) markets. Risk entanglement is a refinement of incomplete markets that some risks in asset markets cannot be singly traded. We show that in FX markets with entangled risks (i) there exist multiple pricing-consistent exchange rates, (ii) every exchange rate is affected by idiosyncratic risks, and (iii) exchange rates can be smooth while stochastic discount factors (SDFs) are volatile and almost uncorrelated. These results are in stark contrast to the case of complete markets or incomplete markets without risk entanglements.
Stefano Giglio
University of Chicago
Carolin Pflueger
University of British Columbia
Riccardo Colacito
University of North Carolina-Chapel Hill
Matteo Maggiori
Harvard University
JEL Classifications
  • G1 - Asset Markets and Pricing