International Correlation Risk
70 Pages Posted: 3 May 2012 Last revised: 29 Oct 2016
Date Written: October 26, 2016
We document that the cross-sectional dispersion of conditional FX correlation is countercyclical and that currencies that perform badly (well) during periods of high dispersion yield high (low) average excess returns. We also find a negative cross-sectional association between average FX correlations and average option-implied FX correlation risk premiums. Our findings show that while investors in spot currency markets require a positive risk premium for exposure to high-dispersion states, FX option prices are consistent with investors being compensated for the risk of low-dispersion states. To address our empirical findings, we propose a no-arbitrage model that features unspanned FX correlation risk.
Keywords: Correlation Risk, Exchange Rates, International Finance
JEL Classification: F31, G15
Suggested Citation: Suggested Citation