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Foreign exchange rate risk in a small open economy

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  • De Paoli, Bianca

    ()
    (Bank of England)

  • Sondergaard, Jens

    ()
    (Bank of England)

Abstract

Resolving the forward premium puzzle requires a volatile foreign exchange rate risk premium that covaries negatively with the expected depreciation rate. Earlier work has shown how models featuring consumption habits can generate such premia when either trade costs or 'deep habits' are assumed. We show that as long as consumption habits are slow-moving and shocks are highly persistent, a standard small open endowment economy - without any additional features - can address the puzzle. Moreover endogenising the labour supply decision in the small open economy can improve the model's ability to match risk premia observations so long as it makes business cycles less synchronised.

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Bibliographic Info

Paper provided by Bank of England in its series Bank of England working papers with number 365.

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Length: 31 pages
Date of creation: 20 Mar 2009
Date of revision:
Handle: RePEc:boe:boeewp:0365

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  1. V.V. Chari & Patrick J. Kehoe & Ellen R. McGrattan, 2002. "Can sticky price models generate volatile and persistent real exchange rates?," Staff Report 277, Federal Reserve Bank of Minneapolis.
  2. De Paoli, Bianca & Zabczyk, Pawel, 2009. "Why do risk premia vary over time? A theoretical investigation under habit formation," Bank of England working papers 361, Bank of England.
  3. Pasquale Della Corte & Lucio Sarno & Ilias Tsiakas, 2009. "An Economic Evaluation of Empirical Exchange Rate Models," Review of Financial Studies, Society for Financial Studies, vol. 22(9), pages 3491-3530, September.
  4. Adrien Verdelhan, 2006. "A Habit-Based Explanation of the Exchange Rate Risk Premium," 2006 Meeting Papers 872, Society for Economic Dynamics.
  5. Maurice J. Roche & Michael J. Moore, 2009. "Solving Exchange Rate Puzzles with neither Sticky Prices nor Trade Costs," Working Papers 001, Ryerson University, Department of Economics.
  6. Bianca De Paoli, 2004. "Monetary Policy and Welfare in a Small Open Economy," CEP Discussion Papers dp0639, Centre for Economic Performance, LSE.
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Cited by:
  1. Vít Pošta, 2012. "Estimation of the Time-Varying Risk Premium in the Czech Foreign Exchange Market," Prague Economic Papers, University of Economics, Prague, vol. 2012(1), pages 3-17.
  2. Groth, Charlotta & Zampolli, Fabrizio, 2010. "Macroeconomic stability and the real interest rate: a cross-country analysis," Discussion Papers 30, Monetary Policy Committee Unit, Bank of England.

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