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Bond risk premia, macroeconomic fundamentals and the exchange rate

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Author Info
Marcello Pericoli () (Bank of Italy)
Marco Taboga () (Bank of Italy)

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Abstract

We introduce a two-country no-arbitrage term-structure model to analyse the joint dynamics of bond yields, macroeconomic variables, and the exchange rate. The model allows to understand how exogenous shocks to the exchange rate affect the yield curves, how bond yields co-move in different countries, and how the exchange rate is influenced by the interactions between macroeconomic variables and time-varying bond risk premia. Estimating the model with US and German data, we obtain an excellent fit of the yield curves and we are able to account for up to 75 per cent of the variability of the exchange rate. We find that time-varying risk premia play a non-negligible role in exchange rate fluctuations due to the fact that a currency tends to appreciate when risk premia on long-term bonds denominated in that currency rise. A number of other novel empirical findings emerge.

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Paper provided by Bank of Italy, Economic Research Department in its series Temi di discussione (Economic working papers) with number 699.

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Date of creation: Jan 2009
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Handle: RePEc:bdi:wptemi:td_699_09

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Related research
Keywords: exchange rate; term structure; UIP;

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Find related papers by JEL classification:
C5 - Mathematical and Quantitative Methods - - Econometric Modeling
E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates
G1 - Financial Economics - - General Financial Markets

This paper has been announced in the following NEP Reports:

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  4. Marcello Pericoli & Marco Taboga, 2008. "Canonical Term-Structure Models with Observable Factors and the Dynamics of Bond Risk Premia," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 40(7), pages 1471-1488, October. [Downloadable!] (restricted)
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  20. Charles Engel, 1996. "The Forward Discount Anomaly and the Risk Premium: A Survey of Recent Evidence," NBER Working Papers 5312, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  29. Brandt, Michael W. & Santa-Clara, Pedro, 2002. "Simulated likelihood estimation of diffusions with an application to exchange rate dynamics in incomplete markets," Journal of Financial Economics, Elsevier, vol. 63(2), pages 161-210, February. [Downloadable!] (restricted)
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