This paper proposes a two-country model that features time-varying heterogeneity in conditional risk aversion across countries, endogenously arising from the interaction between external habit formation and preference home bias. The model generates high international correlation of state prices along with modest cross-country consumption growth correlation and matches the empirical disconnect between exchange rate changes and consumption growth rate differentials. The key mechanism is endogenous time variation in conditional consumption growth volatility: the conditionally less risk averse country insures the more risk averse one, offsetting cross-country heterogeneity in conditional risk aversion and leading to significant international comovement in marginal utility growth. Received February 1, 2012; editorial decision April 19, 2016 by Editor Pietro Veronesi.

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.

We document that the currency denomination of the debt of large firms in developed countries is strongly associated with the geographical distribution of their sales. Furthermore, those firms exhibit significant home currency bias and international currency bias in borrowing: controlling for the geography of sales, they borrow more in their home currency and the two most traded currencies, the US dollar and the euro. We also show that the firms’ debt currency denomination choices are associated with export invoicing currency patterns in a way consistent with a currency hedging mechanism. In particular, firms domiciled in countries that invoice a larger share of their exports in either their home currency or in a vehicle currency exhibit a weaker connection between the currency denomination of their debt and the geography of their sales. Moreover, firms in countries that invoice more of their exports in an international currency are characterized by stronger international currency bias in debt issuance.

We show that the cross-sectional dispersion of conditional foreign exchange (FX) correlation is countercyclical and that currencies that perform badly (well) during periods of high dispersion yield high (low) average excess returns. We also find a negative cross-sectional association between average FX correlations and average option-implied FX correlation risk premiums. Our findings show that while investors in spot currency markets require a positive risk premium for exposure to high dispersion states, FX option prices are consistent with investors being compensated for the risk of low dispersion states. To address our empirical findings, we propose a no-arbitrage model that features unspanned FX correlation risk.