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International correlation risk

Author

Listed:
  • Mueller, Philippe
  • Stathopoulos, Andreas
  • Vedolin, Andrea

Abstract

We provide novel evidence of priced correlation risk in the foreign exchange market. Currencies that perform badly (well) during periods of high exchange rate correlation have high (low) average returns. We also show that high (low) interest rate currencies have high (low) correlation risk exposure, providing a risk-based justification for the carry trade. To address our empirical findings, we consider a general equilibrium model that incorporates preferences characterized by external habit formation and home bias. In our model, currencies which depreciate when conditional exchange rate correlation is high command high risk premia due to their adverse exposure to global risk aversion shocks.

Suggested Citation

  • Mueller, Philippe & Stathopoulos, Andreas & Vedolin, Andrea, 2013. "International correlation risk," LSE Research Online Documents on Economics 43087, London School of Economics and Political Science, LSE Library.
    • Handle: RePEc:ehl:lserod:43087
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    File URL: http://eprints.lse.ac.uk/43087/
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    References listed on IDEAS

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    Cited by:

    1. Ornelas, José Renato Haas & Mauad, Roberto Baltieri, 2019. "Volatility risk premia and future commodity returns," Journal of International Money and Finance, Elsevier, vol. 96(C), pages 341-360.

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    More about this item

    Keywords

    carry trade; correlation risk; habit; international finance; exchange rates;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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