Currency Risk and Central Banks

Abstract

We document that the relationship between currencies and risk premia has changed dramatically since the financial crisis: the covariance of equity returns and exchange rates sharply increased after the crisis. Since 2008, 21 per cent of the variation in monthly currency appreciations can be explained by the interaction of the currency’s conditional equity beta with the contemporaneous return on the US stock market, compared to less than 1 per cent beforehand. We provide evidence that, prior to the crisis, interest rate spreads responded to risk premia changes in a way that decreased the sensitivity of exchange rates to risk premia.