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Switching Risk Off: FX Correlations and Risk Premia

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The recently popularized phrase “risk-off” refers to a change in risk preferences and the effect on asset prices of the associated portfolio rebalancing. We identify these episodes as a switch to a polarized correlation regime of currency returns. These risk-off transitions are relatively infrequent but noticeably increasing over time. They are persistent and associated with geopolitical events. Finally, risk-off switches are unrelated to changes in macroeconomic fundamentals and to volatility or average correlation shocks. Risk-off switches have very significant spill-over to the returns of broad asset classes and active trading strategies, with risky and safe asset returns being penalized and favored, respectively. We document that risk-off switches are associated with significant changes in the positions of professional investors across different financial markets, suggesting that the return evidence is consistent with price pressure induced by portfolio rebalancing.

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