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Risk Appetite and Exchange Rates

  • Hyun Song Shin

    (Princeton University)

  • Erkko Etula

    (Federal Reserve Bank of New York)

  • Tobias Adrian

    (Federal Reserve Bank of New York)

We present evidence that the funding liquidity aggregates of U.S. financial intermediaries forecast exchange rate growth---at weekly, monthly, and quarterly horizons, both in-sample and out-of-sample, and for a large set of currencies. We estimate prices of risk using a cross-sectional asset pricing approach and show that U.S. dollar funding liquidity forecasts exchange rates because of its association with time-varying risk premia. We provide a theoretical foundation for a funding liquidity channel in an intertemporal equilibrium pricing model where the "risk appetite" of dollar-funded intermediaries fluctuates with the tightness of their balance sheet constraints. Our empirical evidence shows that this channel is separate from the more familiar "carry trade" channel.

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Paper provided by Society for Economic Dynamics in its series 2010 Meeting Papers with number 311.

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Date of creation: 2010
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Handle: RePEc:red:sed010:311
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Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA

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