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International Correlation Risk

  • Philippe Mueller
  • Andreas Stathopoulos
  • Andrea Vedolin

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.

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Paper provided by Financial Markets Group in its series FMG Discussion Papers with number dp716.

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Handle: RePEc:fmg:fmgdps:dp716
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