Fixing the investment horizon, the returns to currency carry trades decrease as the maturity of the foreign bonds increases. Across developed countries, the local currency term premia, which increase with the maturity of the bonds, offset the currency risk premia. Similarly, in the time-series, the predictability of foreign bond returns in dollars declines with the bonds’ maturities. Leading no-arbitrage models in international finance do not match the downward term structure of currency carry trade risk premia. We derive a simple preference-free condition that no-arbitrage models need to reproduce in the absence of carry trade risk premia on long-term bonds. (JEL E43, G12, G15)

We document that cross-sectional FX correlation disparity is countercyclical, as exchange rate pairs with high average correlation become more correlated in bad times whereas pairs with low average correlation become less correlated. We show that currencies that perform badly (well) during periods of high cross-sectional disparity in conditional FX correlation yield high (low) average excess returns, suggesting that correlation risk is priced in currency markets. Furthermore, we find a negative crosssectional relationship between average FX correlations and average FX correlation risk premia. Finally, we propose a no-arbitrage model that can match salient properties of FX correlations and correlation risk premia. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means without the prior permission in writing of the publisher nor be issued to the public or circulated in any form other than that in which it is published. KeywordsRequests for permission to reproduce any article or part of the Working Paper should be sent to the editor at the above address. AbstractWe document that cross-sectional FX correlation disparity is countercyclical, as exchange rate pairs with high average correlation become more correlated in bad times whereas pairs with low average correlation become less correlated. We show that currencies that perform badly (well) during periods of high cross-sectional disparity in conditional FX correlation yield high (low) average excess returns, suggesting that correlation risk is priced in currency markets. Furthermore, we find a negative cross-sectional relationship between average FX correlations and average FX correlation risk premia. Finally, we propose a no-arbitrage model that can match salient properties of FX correlations and correlation risk premia.

We document that cross-sectional FX correlation disparity is countercyclical, as exchange rate pairs with high average correlation become more correlated in bad times whereas pairs with low average correlation become less correlated. We show that currencies that perform badly (well) during periods of high cross-sectional disparity in conditional FX correlation yield high (low) average excess returns, suggesting that correlation risk is priced in currency markets. Furthermore, we find a negative crosssectional relationship between average FX correlations and average FX correlation risk premia. Finally, we propose a no-arbitrage model that can match salient properties of FX correlations and correlation risk premia. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means without the prior permission in writing of the publisher nor be issued to the public or circulated in any form other than that in which it is published. KeywordsRequests for permission to reproduce any article or part of the Working Paper should be sent to the editor at the above address. AbstractWe document that cross-sectional FX correlation disparity is countercyclical, as exchange rate pairs with high average correlation become more correlated in bad times whereas pairs with low average correlation become less correlated. We show that currencies that perform badly (well) during periods of high cross-sectional disparity in conditional FX correlation yield high (low) average excess returns, suggesting that correlation risk is priced in currency markets. Furthermore, we find a negative cross-sectional relationship between average FX correlations and average FX correlation risk premia. Finally, we propose a no-arbitrage model that can match salient properties of FX correlations and correlation risk premia.

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