Risk Appetite and Exchange Rates - FEDERAL RESERVE BANK of NEW YORK

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Staff Reports

Risk Appetite and Exchange Rates

Previous title: “Global Liquidity and Exchange Rates”

January 2009 Number 361
Revised December 2015

JEL classification: F30, F31, G12, G24

Authors: Tobias Adrian, Erkko Etula, and Hyun Song Shin

We present evidence that the growth of U.S.-dollar-denominated banking sector liabilities forecasts appreciations of the U.S. dollar, both in-sample and out-of-sample, against a large set of foreign currencies. We provide a theoretical foundation for a funding liquidity channel in a global banking model where exchange rates fluctuate as a function of banks’ balance sheet capacity. We estimate prices of risk using a cross-sectional asset pricing approach and show that the U.S. dollar funding liquidity forecasts exchange rates because of its association with time-varying risk premia. Our empirical evidence shows that this channel is separate from the more familiar “carry trade” channel. Although the financial crisis of 2007-09 induced a structural shift in our forecasting variables, when we control for this shift, the forecasting relationship is preserved.

Available only in PDF PDF

37 pages / 779 kb

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