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Dusting off the Perception of Risk and Returns in FOREX Markets

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  • Phornchanok Cumperayot
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    Abstract

    In this paper, we construct alternative theoretical models for exchange rates by introducing additional risk factors, based on the volatility of macroeconomic fundamentals. The modified flexible-price monetary model is used to characterize the long-run equilibrium of exchange rates, while the modified sticky-price model explains the adjustment towards the long run. Empirically, in a number of OECD countries we find cointegration relationships between the exchange rate and macroeconomic variables and also some evidence for the long-run equilibrium error correction. Macroeconomic uncertainty can significantly explain the variation of the exchange rate from its fundamental-based value. The results lead us to believe that macroeconomic sources of FOREX risk may be a missing factor in the exchange rate study.

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    Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number 904.

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    Date of creation: 2003
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    Handle: RePEc:ces:ceswps:_904

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    Keywords: flexible-price and sluggish-price exchange rate models; expectation formations; macroeconomic risk; risk premium; asset pricing;

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