International Correlation Risk

Foreign exchange correlation is a key driver of risk premia in the cross-section of carry trade returns. First, we show that the correlation risk premium, defined as the difference between the risk-neutral and objective measure correlation is large (15% per year) and highly time-varying. Second, sorting currencies according to their exposure with correlation innovations yields portfolios with attractive risk and return characteristics. We also find that high (low) interest rate currencies have negative (positive) loadings on the correlation risk factor. To address our empirical findings, we consider a multi-country general equilibrium model with time-varying risk aversion generated by external habit preferences. In the model, currency risk premia mostly compensate for exposure to global risk aversion, defined as a weighted average of country risk aversions. Given countercyclical real interest rates, the model can also address the forward premium puzzle, as high interest rate currencies are exposed to (while low interest rate currencies provide a hedge to) global risk aversion risk. We also show that high global risk aversion is associated with high conditional exchange rate variance and covariance, providing theoretical justification for sorting currencies on their exposure to fluctuations of exchange rate conditional second moments.