IDEAS home Printed from https://ideas.repec.org/p/ehl/lserod/84140.html
   My bibliography  Save this paper

International correlation risk

Author

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

Abstract

We show that the cross-sectional dispersion of conditional foreign exchange (FX) correlation is countercyclical and that currencies that perform badly (well) during periods of high dispersion yield high (low) average excess returns. We also find a negative cross-sectional association between average FX correlations and average option-implied FX correlation risk premiums. Our findings show that while investors in spot currency markets require a positive risk premium for exposure to high dispersion states, FX option prices are consistent with investors being compensated for the risk of low dispersion states. To address our empirical findings, we propose a no-arbitrage model that features unspanned FX correlation risk.

Suggested Citation

  • Mueller, Philippe & Stathopoulos, Andreas & Vedolin, Andrea, 2017. "International correlation risk," LSE Research Online Documents on Economics 84140, London School of Economics and Political Science, LSE Library.
  • Handle: RePEc:ehl:lserod:84140
    as

    Download full text from publisher

    File URL: http://eprints.lse.ac.uk/84140/
    File Function: Open access version.
    Download Restriction: no

    References listed on IDEAS

    as
    1. Farhi, Emmanuel & Fraiberger, Samuel P. & Gabaix, Xavier & Rancière, Romain & Verdelhan, Adrien, 2009. "Crash Risk in Currency Markets," CEPR Discussion Papers 7322, C.E.P.R. Discussion Papers.
    2. Roman Kozhan & Wing Wah Tham, 2012. "Execution Risk in High-Frequency Arbitrage," Management Science, INFORMS, vol. 58(11), pages 2131-2149, November.
    3. Tim Bollerslev & George Tauchen & Hao Zhou, 2009. "Expected Stock Returns and Variance Risk Premia," Review of Financial Studies, Society for Financial Studies, vol. 22(11), pages 4463-4492, November.
    4. Lukas Menkhoff & Lucio Sarno & Maik Schmeling & Andreas Schrimpf, 2012. "Carry Trades and Global Foreign Exchange Volatility," Journal of Finance, American Finance Association, vol. 67(2), pages 681-718, April.
    5. Shanken, Jay, 1992. "On the Estimation of Beta-Pricing Models," Review of Financial Studies, Society for Financial Studies, vol. 5(1), pages 1-33.
    6. Hanno Lustig & Nikolai Roussanov & Adrien Verdelhan, 2011. "Common Risk Factors in Currency Markets," Review of Financial Studies, Society for Financial Studies, vol. 24(11), pages 3731-3777.
    7. Riccardo Colacito & Mariano M. Croce, 2013. "International Asset Pricing with Recursive Preferences," Journal of Finance, American Finance Association, vol. 68(6), pages 2651-2686, December.
    8. Grace Xing Hu & Jun Pan & Jiang Wang, 2013. "Noise as Information for Illiquidity," Journal of Finance, American Finance Association, vol. 68(6), pages 2341-2382, December.
    9. repec:cup:jfinqa:v:53:y:2018:i:01:p:137-170_00 is not listed on IDEAS
    10. Chernov, Mikhail & Graveline, Jeremy & Zviadadze, Irina, 2018. "Crash Risk in Currency Returns," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 53(01), pages 137-170, February.
    11. Joost Driessen & Pascal J. Maenhout & Grigory Vilkov, 2009. "The Price of Correlation Risk: Evidence from Equity Options," Journal of Finance, American Finance Association, vol. 64(3), pages 1377-1406, June.
    12. Michael W. Brandt & Francis X. Diebold, 2006. "A No-Arbitrage Approach to Range-Based Estimation of Return Covariances and Correlations," The Journal of Business, University of Chicago Press, vol. 79(1), pages 61-74, January.
    13. Jurek, Jakub W., 2014. "Crash-neutral currency carry trades," Journal of Financial Economics, Elsevier, vol. 113(3), pages 325-347.
    14. Robert Ready & Mariano Croce & Federico Gavazzoni & Riccardo Colacito, 2016. "Currency Risk Factors in a Recursive Multi-Country Economy," 2016 Meeting Papers 297, Society for Economic Dynamics.
    15. Philippe Mueller & Gyuri Venter & Andrea Vedolin & Aytek Malkhozov, 2014. "International Liquidity CAPM," 2014 Meeting Papers 1165, Society for Economic Dynamics.
    16. repec:wsi:ijtafx:v:12:y:2009:i:08:n:s0219024909005609 is not listed on IDEAS
    17. White, Halbert, 1980. "A Heteroskedasticity-Consistent Covariance Matrix Estimator and a Direct Test for Heteroskedasticity," Econometrica, Econometric Society, vol. 48(4), pages 817-838, May.
    18. George J. Jiang & Yisong S. Tian, 2005. "The Model-Free Implied Volatility and Its Information Content," Review of Financial Studies, Society for Financial Studies, vol. 18(4), pages 1305-1342.
    19. Newey, Whitney & West, Kenneth, 2014. "A simple, positive semi-definite, heteroscedasticity and autocorrelation consistent covariance matrix," Applied Econometrics, Publishing House "SINERGIA PRESS", vol. 33(1), pages 125-132.
    20. Garman, Mark B. & Kohlhagen, Steven W., 1983. "Foreign currency option values," Journal of International Money and Finance, Elsevier, vol. 2(3), pages 231-237, December.
    21. Lustig, Hanno & Roussanov, Nikolai & Verdelhan, Adrien, 2014. "Countercyclical currency risk premia," Journal of Financial Economics, Elsevier, vol. 111(3), pages 527-553.
    22. Fama, Eugene F., 1984. "Forward and spot exchange rates," Journal of Monetary Economics, Elsevier, vol. 14(3), pages 319-338, November.
    23. David K. Backus & Federico Gavazzoni & Christopher Telmer & Stanley E. Zin, 2010. "Monetary Policy and the Uncovered Interest Parity Puzzle," NBER Working Papers 16218, National Bureau of Economic Research, Inc.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Colacito, Riccardo & Croce, Mariano Massimiliano & Liu, Yang & Shaliastovich, Ivan, 2018. "Volatility Risk Pass-Through," CEPR Discussion Papers 13325, C.E.P.R. Discussion Papers.
    2. repec:wly:jfutmk:v:39:y:2019:i:1:p:128-146 is not listed on IDEAS
    3. repec:eee:jbfina:v:101:y:2019:i:c:p:92-103 is not listed on IDEAS
    4. Natalie Packham & Fabian Woebbeking, 2018. "A factor-model approach for correlation scenarios and correlation stress-testing," Papers 1807.11381, arXiv.org, revised Jan 2019.

    More about this item

    Keywords

    correlation risk; exchange rate; international finance;

    JEL classification:

    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • F3 - International Economics - - International Finance
    • G3 - Financial Economics - - Corporate Finance and Governance

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:ehl:lserod:84140. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (LSERO Manager). General contact details of provider: http://edirc.repec.org/data/lsepsuk.html .

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service hosted by the Research Division of the Federal Reserve Bank of St. Louis . RePEc uses bibliographic data supplied by the respective publishers.