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Foreign Exchange Risk Premium

Paper Session

Saturday, Jan. 4, 2020 2:30 PM - 4:30 PM (PDT)

Manchester Grand Hyatt, Seaport F
Hosted By: American Finance Association
  • Chair: Wenxin Du, University of Chicago

Foreign Exchange Fixings and Returns Around the Clock

Ingomar Krohn
,
Copenhagen Business School
Philippe Mueller
,
University of Warwick
Paul Whelan
,
Copenhagen Business School

Abstract

This paper documents a new stylised fact in foreign exchange markets: intraday currency returns display prolonged reversals around the major benchmark fixings, characterised by an appreciation of the U.S. dollar pre-fixing and a depreciation thereafter. Tracing returns around the clock, the major fixing during Asian trading hours (Tokyo) and two major fixings during European and U.S. hours (Frankfurt and London) generate a distinct `W' shaped return pattern over the 24-hour trading day. On either side of the reversal, price drifts persist for hours; moreover, they are a systematic feature of the data being present every day of the week, month of the year, and during each of the 20 years in our sample. We argue these findings require two ingredients (i) a structural demand for dollar immediacy at local currency fixing times; and (ii) pre-fix hedging risk management practices by financial intermediaries. Consistent with this conjecture, we show our findings are amplified in states of high anticipated volatility, low liquidity, and that `arbitrageurs' can exploit these patterns after taking transaction costs into account.

Intermediary Leverage and Currency Risk Premium

Xiang Fang
,
University of Pennsylvania

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.

A Credit-Based Theory of the Currency Risk Premium

Pasquale Della Corte
,
Imperial College London
Alexandre Jeanneret
,
HEC Montreal
Ella Patelli
,
HEC Montreal

Abstract

This 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

Sai Ma
,
Federal Reserve Board
Shaojun Zhang
,
Ohio State University

Abstract

Exchange 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
Discussant(s)
Alain Chaboud
,
Federal Reserve Board
Carolin Pflueger
,
University of British Columbia
Lukas Kremens
,
London School of Economics
Nancy Xu
,
Boston College
JEL Classifications
  • G1 - General Financial Markets