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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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File URL: https://www.economicdynamics.org/meetpapers/2010/paper_311.pdf
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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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  1. Fama, Eugene F., 1984. "Forward and spot exchange rates," Journal of Monetary Economics, Elsevier, vol. 14(3), pages 319-338, November.
  2. Douglas W. Diamond & Raghuram G. Rajan, 2002. "Liquidity Shortages and Banking Crises," NBER Working Papers 8937, National Bureau of Economic Research, Inc.
  3. Adrian, Tobias & Crump, Richard K. & Moench, Emanuel, 2013. "Pricing the term structure with linear regressions," Journal of Financial Economics, Elsevier, vol. 110(1), pages 110-138.
  4. Craig Burnside & Martin Eichenbaum & Isaac Kleshchelski & Sergio Rebelo, 2006. "The Returns to Currency Speculation," 2006 Meeting Papers 864, Society for Economic Dynamics.
  5. Charles Engel & Nelson C. Mark & Kenneth D. West, 2008. "Exchange Rate Models Are Not As Bad As You Think," NBER Chapters, in: NBER Macroeconomics Annual 2007, Volume 22, pages 381-441 National Bureau of Economic Research, Inc.
  6. Meese, Richard A. & Rogoff, Kenneth, 1983. "Empirical exchange rate models of the seventies : Do they fit out of sample?," Journal of International Economics, Elsevier, vol. 14(1-2), pages 3-24, February.
  7. Kenneth S. Rogoff & Vania Stavrakeva, 2008. "The Continuing Puzzle of Short Horizon Exchange Rate Forecasting," NBER Working Papers 14071, National Bureau of Economic Research, Inc.
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