Foreign Exchange Risk Premium
Saturday, Jan. 4, 2020 2:30 PM - 4:30 PM (PDT)
- Chair: Wenxin Du, University of Chicago
Intermediary Leverage and Currency Risk Premium
AbstractThis 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.
A Credit-Based Theory of the Currency Risk Premium
AbstractThis paper extends the work of Kremens and Martin (2019) and uncovers a novel component for exchange rate predictability. Our theory shows that currency returns compensate investors for the expected currency depreciation in the case of a severe but rare credit event. We compute this risk compensation – the credit-implied risk premium (CRP) – by exploiting the price difference between sovereign credit default swaps denominated in different currencies. Using data for 17 Eurozone countries over the period 2010-19, we find that CRP positively forecasts the euro-dollar exchange rate return between one-week and six-month horizon, both in-sample and out-of-sample. We also show that currency trading strategies that exploit the informative content of CRP generate substantial out-of-sample economic value.
Housing Cycles and Exchange Rates
AbstractExchange rates are stubbornly disconnected from macroeconomic fundamentals. This paper documents that the ratio of residential-to-nonresidential investment is a strong in-sample and out-of-sample for the dollar up to twelve quarters. The measure captures investment in the nontradable relative to tradable sector and drives dollar variations through relative price adjustments. The required dollar premium further varies as the expected fraction of nontradable output fluctuates, suggesting limited international risk sharing. Alternative explanations, including aggregate risk, capital flows, and time-varying market segmentation, find less empirical support. The predictability is robust to a host of additional checks and holds for other G10 currencies
- G1 - General Financial Markets