Fed intervention, dollar appreciation, and systematic risk

Abstract

In a four-factor asset-pricing model estimated on daily data, Fed intervention significantly affects betas of surprises in the market return, expected inflation rate, yield curve, and corporate-bond risk premium. Fed foreign-currency sales cause economically and statistically significant increases in the systematic risk premium in appreciation and thus in the dollar's expected appreciation rate, the direction the Fed desires, and consistent with the signaling but not the portfolio balance channel. Intervention's effects on actual appreciation are less reliable; they depend on unpredictable risk-factor realizations. Even successful intervention to strengthen the dollar may be costly; by increasing the dollar's systematic risk, intervention reduces the attractiveness of U.S. relative to foreign investments. Further, uncertainty about future Fed interventions may induce resource misallocation: ceteris paribus, investors find it harder to estimate risk-adjusted discount rates and forecast the home-currency value of cash flows.