The behavior of currencies during risk-off episodes

• Episodes of global risk aversion have become more frequent since 2007.
• Exchange rates display a number of recurring patterns during such risk-off episodes.
• Macroeconomic variables and market-liquidity factors help to explain these patterns.
• Currencies with higher policy rates have become more vulnerable in a risk-off episode since 2007.

Episodes of increased global risk aversion, also known as risk-off episodes, have become more frequent and severe since 2007. During these episodes, currency markets exhibit recurrent patterns, as the Japanese yen, Swiss franc, and U.S. dollar appreciate against other G-10 and emerging market currencies. The pattern of these moves can be explained by a combination of fundamental factors, such as the nominal interest rate, the international investment position and measures of exchange rate misalignment, and market-liquidity factors, such as bid-offer spreads and restrictions on international capital flows. We also find that currency performance in a risk-off episode has become more related to a currency's yield and relationship to broader risks in recent years.