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Bond risk premia, macroeconomic fundamentals and the exchange rate

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  • Marcello Pericoli

    ()
    (Bank of Italy)

  • Marco Taboga

    ()
    (Bank of Italy)

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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Bibliographic Info

Paper provided by Bank of Italy, Economic Research and International Relations Area 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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Keywords: exchange rate; term structure; UIP;

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Cited by:
  1. Gregory H. Bauer & Antonio Diez de los Rios, 2012. "An International Dynamic Term Structure Model with Economic Restrictions and Unspanned Risks," Working Papers 12-5, Bank of Canada.

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