Risk Appetite and Exchange Rates

Abstract

We present evidence that the funding liquidity aggregates of U.S. …nan-cial 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 ‡uctuates with the tightness of their balance sheet constraints. Our empirical evidence shows that this channel is separate from the more familiar "carry trade" channel.

Carry Trades and the Performance of Currency Hedge Funds

“…Furthermore, Patton and Ramadorai (2012) also document that systematic risk exposures are associated with liquidity dynamics. Finally, Pojarliev and Levich (2008) show that currency momentum strategies returns are strongly correlated with hedge fund returns and Burnside et al (2011b) and Menkhoff et al (2012b) Adrian et al (2009) who find that it is able to explain the dynamics of foreign exchange returns, and Patton and Ramadorai (2012) that note that the systematic risk exposures of hedge funds depend upon the level of leverage they choose. resulting mimicking portfolio returns we estimate equation (10) recursively using a constant rolling window of 12 month.…”

Portfolio Reallocation and Exchange Rate Dynamics

“…Their conclusion seemed to hold during the 1990s but is contradicted by the events of 2008. Adrian, Etula, and Shin (2009) suggest that high leverage is followed by the appreciation of the USD.…”

“…Motivated by the …nancial crisis in 2008, researchers have examined more speci…c features of market participants : Brunnermeier, Nagel, and Pedersen (2008) and Gagnon and Chaboud (2007) …nd that a popular FX arbitrage strategy -the carry trade -may play an important role in exchange rate determination, while Adrian, Etula, and Shin (2009) …nd a connection between exchange rates and risk appetite, arguing that high leverage is followed by appreciation of the USD. Supporting evidence presented by these studies, however, is either limited to certain currencies and periods, or obtained through panel data regression, which could hide inconsistencies across currencies and periods.…”

How have global shocks impacted the real effective exchange rates of individual euro area countries since the euro’s creation?

“…McGuire (2009), Adrian, Etula, and Shin (2010)). 12 We remain somewhat agnostic when identifying such risk aversion shocks and, to that end, impose "weak" sign restrictions on selected currencies.…”

“…Data and 6 Changes in risk aversion and appetite are regarded as important drivers of foreign exchange markets, not only when it comes to emerging market economies but also, more recently, to advanced economies (e.g. McCauley andMcGuire (2009), Adrian, Etula, andShin (2010)). For a recent discussion of risk aversion shocks, see also Popescu and Smets (2010).…”