Investors earn positive excess returns on high interest rate foreign discount bonds, because these currencies appreciate on average. Lustig and Verdelhan (2005) show that investing in high interest rate foreign discount bonds exposes them to more aggregate consumption risk, while low interest rate foreign bonds provide a hedge. This paper provides a simple model that replicates these facts. Investing in foreign currency is like betting on the difference between your own intertemporal marginal rate of substitution (IMRS) and your neighbor's IMRS. These bets are very risky if your neighbor's IMRS is not correlated with yours, but they provide a hedge when his IMRS is highly correlated and more volatile. If the foreign neighbors that face low interest rates also have more volatile and correlated IMRS, that accounts for the spread in excess returns in the data. (JEL: F31, G12) (c) 2006 by the European Economic Association.
Download Info
To download:
If you experience problems downloading a file, check if you have the
proper application to
view it first. Information about this may be contained
in the File-Format links below. 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.
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.
Volume (Year): 4 (2006) Issue (Month): 2-3 (04-05) Pages: 644-655 Download reference. The following formats are available: HTML
(with abstract),
plain text
(with abstract),
BibTeX,
RIS (EndNote, RefMan, ProCite),
ReDIF
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.: