An unconventional FX tail risk story

We examine how the tail risk of currency returns of nine countries, from 2000 to 2020, were impacted by central bank monetary and liquidity measures across the globe with an original and unique dataset that we make publicly available. Using a standard factor model, we derive theoretical measures of tail risks of currency returns which we then relate to the various policy instruments employed by central banks. We find empirical evidence for the existence of a cross-border transmission channel of central bank policy through the FX market. The tail impact is particularly sizeable for asset purchases and swap lines. The effects last for up to one month, and are proportionally higher in a hypothetical joint QE action scenario. This cross-border source of tail risk is largely undiversifiable, even after controlling for the US dollar dominance and the effects of its own monetary policy stance.