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International Correlation Risk

Author

Listed:
  • Philippe Mueller
  • Andreas Stathopoulos
  • Andrea Vedolin

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

  • Philippe Mueller & Andreas Stathopoulos & Andrea Vedolin, "undated". "International Correlation Risk," FMG Discussion Papers dp716, Financial Markets Group.
    • Handle: RePEc:fmg:fmgdps:dp716
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    File URL: http://www.lse.ac.uk/fmg/workingPapers/discussionPapers/fmgdps/dp716.pdf
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    More about this item

    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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