Exchange Rate Risk in Central European Countries

The authors address the issue of foreign exchange risk and its macroeconomic determinants in several Central European (CE) economies. The joint distribution of excess returns in the foreign exchange market and observable country-specific macroeconomic factors is modeled using the stochastic discount factor (SDF) approach and a multivariate GARCH-in-mean model. The authors find that real factors seem to lack significance in determining foreign exchange risk, while nominal factors (inflation and money) have a significant impact. The differences in the impact of nominal factors are related to the actual monetary policy regimes adopted in the countries examined. The authors´ findings have policy implications with respect to currency stability. The central banks in the CE countries should continue stabilization policies aimed at achieving nominal convergence with the core EU members, as nominal country-specific factors play a crucial role in explaining the variability of the risk premium.