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Risk appetite and exchange Rates

  • Adrian, Tobias

    (Federal Reserve Bank of New York)

  • Etula, Erkko
  • Shin, Hyun Song

We present evidence that the growth of U.S.-dollar-denominated banking sector liabilities forecasts appreciations of the U.S. dollar, both in-sample and out-of-sample, against a large set of foreign currencies. We provide a theoretical foundation for a funding liquidity channel in a global banking model where exchange rates fluctuate as a function of banks’ balance sheet capacity. We estimate prices of risk using a cross-sectional asset pricing approach and show that the U.S. dollar funding liquidity forecasts exchange rates because of its association with time-varying risk premia. Our empirical evidence shows that this channel is separate from the more familiar “carry trade” channel. Although the financial crisis of 2007-09 induced a structural shift in our forecasting variables, when we control for this shift, the forecasting relationship is preserved.

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Paper provided by Federal Reserve Bank of New York in its series Staff Reports with number 361.

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Length: 37 pages
Date of creation: 2009
Date of revision: 10 Dec 2015
Handle: RePEc:fip:fednsr:361
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