Advanced Search
MyIDEAS: Login

A Habit-Based Explanation of the Exchange Rate Risk Premium

Contents:

Author Info

  • ADRIEN VERDELHAN

Abstract

This paper presents a model that reproduces the uncovered interest rate parity puzzle. Investors have preferences with external habits. Countercyclical risk premia and procyclical real interest rates arise endogenously. During bad times at home, when domestic consumption is close to the habit level, the representative investor is very risk averse. When the domestic investor is more risk averse than her foreign counterpart, the exchange rate is closely tied to domestic consumption growth shocks. The domestic investor therefore expects a positive currency excess return. Because interest rates are low in bad times, expected currency excess returns increase with interest rate differentials. Copyright (c) 2009 the American Finance Association.

Download Info

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
File URL: http://www.blackwell-synergy.com/doi/abs/10.1111/j.1540-6261.2009.01525.x
File Function: link to full text
Download Restriction: Access to full text is restricted to subscribers.

As the access to this document is restricted, you may want to look for a different version under "Related research" (further below) or search for a different version of it.

Bibliographic Info

Article provided by American Finance Association in its journal The Journal of Finance.

Volume (Year): 65 (2010)
Issue (Month): 1 (02)
Pages: 123-146

as in new window
Handle: RePEc:bla:jfinan:v:65:y:2010:i:1:p:123-146

Contact details of provider:
Web page: http://www.afajof.org/
More information through EDIRC

Order Information:
Web: http://www.afajof.org/membership/join.asp

Related research

Keywords:

Other versions of this item:

Find related papers by JEL classification:

References

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
as in new window
  1. Epstein, Larry G & Zin, Stanley E, 1989. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: A Theoretical Framework," Econometrica, Econometric Society, vol. 57(4), pages 937-69, July.
  2. Breeden, Douglas T & Litzenberger, Robert H, 1978. "Prices of State-contingent Claims Implicit in Option Prices," The Journal of Business, University of Chicago Press, vol. 51(4), pages 621-51, October.
  3. Yeung Lewis Chan & Leonid Kogan, 2002. "Catching Up with the Joneses: Heterogeneous Preferences and the Dynamics of Asset Prices," Journal of Political Economy, University of Chicago Press, vol. 110(6), pages 1255-1285, December.
  4. G. Constantinides, 1990. "Habit formation: a resolution of the equity premium puzzle," Levine's Working Paper Archive 1397, David K. Levine.
  5. Jér�me B. Detemple & René Garcia & Marcel Rindisbacher, 2003. "A Monte Carlo Method for Optimal Portfolios," Journal of Finance, American Finance Association, vol. 58(1), pages 401-446, 02.
  6. Wachter, Jessica A., 2006. "A consumption-based model of the term structure of interest rates," Journal of Financial Economics, Elsevier, vol. 79(2), pages 365-399, February.
  7. Ravi Bansal & Amir Yaron, 2004. "Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles," Journal of Finance, American Finance Association, vol. 59(4), pages 1481-1509, 08.
  8. Dotsey, Michael & Lantz, Carl & Scholl, Brian, 2003. " The Behavior of the Real Rate of Interest," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 35(1), pages 91-110, February.
  9. Monika Piazzesi & Martin Schneider, 2006. "Equilibrium Yield Curves," NBER Working Papers 12609, National Bureau of Economic Research, Inc.
    • Monika Piazzesi & Martin Schneider, 2007. "Equilibrium Yield Curves," NBER Chapters, in: NBER Macroeconomics Annual 2006, Volume 21, pages 389-472 National Bureau of Economic Research, Inc.
  10. Fama, Eugene F. & French, Kenneth R., 1993. "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 33(1), pages 3-56, February.
  11. Adrien Verdelhan & Hanno Lustig, 2005. "The Cross-Section Of Foreign Currency Risk Premia And Consumption Growth Risk," Boston University - Department of Economics - Working Papers Series WP2005-019, Boston University - Department of Economics.
  12. Campbell, John & Yogo, Motohiro, 2006. "Efficient tests of stock return predictability," Scholarly Articles 3122601, Harvard University Department of Economics.
  13. Giancarlo Corsetti & Luca Dedola & Sylvain Leduc, 2008. "International Risk Sharing and the Transmission of Productivity Shocks," Review of Economic Studies, Oxford University Press, vol. 75(2), pages 443-473.
  14. Fama, Eugene F., 1984. "Forward and spot exchange rates," Journal of Monetary Economics, Elsevier, vol. 14(3), pages 319-338, November.
  15. Martin D. D. Evans, 1998. "Real Rates, Expected Inflation, and Inflation Risk Premia," Journal of Finance, American Finance Association, vol. 53(1), pages 187-218, 02.
  16. Martin Lettau & Harald Uhlig, 2000. "Can Habit Formation be Reconciled with Business Cycle Facts?," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 3(1), pages 79-99, January.
  17. Hansen, Lars Peter, 1982. "Large Sample Properties of Generalized Method of Moments Estimators," Econometrica, Econometric Society, vol. 50(4), pages 1029-54, July.
  18. Benigno, Gianluca & Thoenissen, Christoph, 2006. "Consumption and Real Exchange Rates with Incomplete Markets and Non-Traded Goods," CEPR Discussion Papers 5580, C.E.P.R. Discussion Papers.
  19. Frachot, Antoine, 1996. "A reexamination of the uncovered interest rate parity hypothesis," Journal of International Money and Finance, Elsevier, vol. 15(3), pages 419-437, June.
  20. V.V. Chari & Patrick J. Kehoe & Ellen R. McGrattan, 2000. "Can Sticky Price Models Generate Volatile and Persistent Real Exchange Rates?," NBER Working Papers 7869, National Bureau of Economic Research, Inc.
  21. Jermann, Urban J., 1998. "Asset pricing in production economies," Journal of Monetary Economics, Elsevier, vol. 41(2), pages 257-275, April.
  22. Emmanuel Farhi & Xavier Gabaix, 2008. "Rare Disasters and Exchange Rates," NBER Working Papers 13805, National Bureau of Economic Research, Inc.
  23. Train,Kenneth E., 2009. "Discrete Choice Methods with Simulation," Cambridge Books, Cambridge University Press, number 9780521747387, October.
  24. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
  25. Cochrane, John H. & Campbell, John, 1999. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," Scholarly Articles 3119444, Harvard University Department of Economics.
  26. Hollifield, Burton & Yaron, Amir, 2001. "The Foreign Exchange Risk Premium: Real and Nominal Factors," Working Papers 01-1, University of Pennsylvania, Wharton School, Weiss Center.
  27. Fama, Eugene F. & Schwert, G. William, 1977. "Asset returns and inflation," Journal of Financial Economics, Elsevier, vol. 5(2), pages 115-146, November.
  28. Thomas D. Tallarini, Jr. & Harold H. Zhang, 2005. "External habit and the cyclicality of expected stock returns," Finance and Economics Discussion Series 2005-27, Board of Governors of the Federal Reserve System (U.S.).
  29. Backus, David K. & Smith, Gregor W., 1993. "Consumption and real exchange rates in dynamic economies with non-traded goods," Journal of International Economics, Elsevier, vol. 35(3-4), pages 297-316, November.
  30. James H. Stock & Mark W. Watson, 1998. "Business Cycle Fluctuations in U.S. Macroeconomic Time Series," NBER Working Papers 6528, National Bureau of Economic Research, Inc.
  31. Hansen, Lars Peter & Hodrick, Robert J, 1980. "Forward Exchange Rates as Optimal Predictors of Future Spot Rates: An Econometric Analysis," Journal of Political Economy, University of Chicago Press, vol. 88(5), pages 829-53, October.
  32. Martin Lettau & Stijn Van Nieuwerburgh, 2008. "Reconciling the Return Predictability Evidence," Review of Financial Studies, Society for Financial Studies, vol. 21(4), pages 1607-1652, July.
  33. Ang, Andrew & Bekaert, Geert, 2004. "The Term Structure of Real Rates and Expected Inflation," CEPR Discussion Papers 4518, C.E.P.R. Discussion Papers.
  34. He, Hua & Pages, Henri F, 1993. "Labor Income, Borrowing Constraints, and Equilibrium Asset Prices," Economic Theory, Springer, vol. 3(4), pages 663-96, October.
  35. Andrea Buraschi & Alexei Jiltsov, 2007. "Habit Formation and Macroeconomic Models of the Term Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 62(6), pages 3009-3063, December.
  36. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
  37. Zvi Bodie & Robert C. Merton & William F. Samuelson, 1992. "Labor Supply Flexibility and Portfolio Choice in a Life-Cycle Model," NBER Working Papers 3954, National Bureau of Economic Research, Inc.
  38. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1985. "A Theory of the Term Structure of Interest Rates," Econometrica, Econometric Society, vol. 53(2), pages 385-407, March.
  39. Lior Menzly & Tano Santos & Pietro Veronesi, 2004. "Understanding Predictability," Journal of Political Economy, University of Chicago Press, vol. 112(1), pages 1-47, February.
  40. Heath, David & Jarrow, Robert & Morton, Andrew, 1992. "Bond Pricing and the Term Structure of Interest Rates: A New Methodology for Contingent Claims Valuation," Econometrica, Econometric Society, vol. 60(1), pages 77-105, January.
  41. David K. Backus, 2001. "Affine Term Structure Models and the Forward Premium Anomaly," Journal of Finance, American Finance Association, vol. 56(1), pages 279-304, 02.
  42. Harvey, Campbell R., 1989. "Time-varying conditional covariances in tests of asset pricing models," Journal of Financial Economics, Elsevier, vol. 24(2), pages 289-317.
  43. Nicole El Karoui & Monique Jeanblanc-Picqué, 1998. "Optimization of consumption with labor income," Finance and Stochastics, Springer, vol. 2(4), pages 409-440.
  44. Detemple, Jérôme & Garcia, René & Rindisbacher, Marcel, 2005. "Intertemporal asset allocation: A comparison of methods," Journal of Banking & Finance, Elsevier, vol. 29(11), pages 2821-2848, November.
  45. Nelson, Charles R & Siegel, Andrew F, 1987. "Parsimonious Modeling of Yield Curves," The Journal of Business, University of Chicago Press, vol. 60(4), pages 473-89, October.
  46. Peter Ritchken & L. Sankarasubramanian, 1995. "Volatility Structures Of Forward Rates And The Dynamics Of The Term Structure," Mathematical Finance, Wiley Blackwell, vol. 5(1), pages 55-72.
  47. Bodie, Zvi & Detemple, Jerome B. & Otruba, Susanne & Walter, Stephan, 2004. "Optimal consumption-portfolio choices and retirement planning," Journal of Economic Dynamics and Control, Elsevier, vol. 28(6), pages 1115-1148, March.
Full references (including those not matched with items on IDEAS)

Citations

Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
as in new window

Cited by:
This item has more than 25 citations. To prevent cluttering this page, these citations are listed on a separate page.

Lists

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

Statistics

Access and download statistics

Corrections

When requesting a correction, please mention this item's handle: RePEc:bla:jfinan:v:65:y:2010:i:1:p:123-146. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Wiley-Blackwell Digital Licensing) or (Christopher F. Baum).

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.