Hedging Demand and Foreign Exchange Risk Premia

This paper develops and tests a model of unobservable risk premia in the foreign exchange market. Risk premia in our model are driven by non-marketable income shocks which risk averse agents attempt to hedge by trading foreign currency. We test our model using data on hedging demand in currency futures and find that our proxy for risk premia explains approximately 45 percent of the variation in currency returns at the monthly horizon. We find that innovations in hedging demand Granger cause changes in speculative flows and that hedgers in the currency futures markets appear to be negative feedback traders. We also compare hedging demand in the futures market to customer-dealer order flow from a major international bank and find little relationship between hedging demands and aggregate customer order imbalances. ∗I thank Ash Alankar, John Briginshaw, Mintao Fan, Jacob Sagi, Hayne Leland, Richard Lyons, Terry Marsh, Mark Rubinstein, Mark Seasholes as well as seminar participants at UC Berkeley and Santa Clara University for helpful comments and suggestions. I am indebted to Mike Rosenberg and Bob Lawrie for their insights and access to their data.