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The Foreign Exchange Risk Premium: Real and Nominal Factors

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  • Burton Hollifield
  • Armir Yaron

Abstract

This paper attempts to identify and isolate the channels by which inflation shocks effect the predictable returns available from currency speculation. We apply a general no--arbitrage based model to decompose the risk premium into inflation and real risk and their interactions. Using two different empirical methods to identify these components, we find that virtually none of the predictable variation in returns from currency speculation can be explained empirically by either inflation risk or the relationship between inflation and real risks. Our results imply that for monetary policy to have significant effects on the risk--premia for currency speculation, monetary policy must have little effect on inflation risk, the relationship between real risk and inflation risk, and instead must mainly impact real exchange rate risk.

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Paper provided by Carnegie Mellon University, Tepper School of Business in its series GSIA Working Papers with number 2001-E13.

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Handle: RePEc:cmu:gsiawp:-1655358232

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  1. Bernanke, Ben S & Blinder, Alan S, 1992. "The Federal Funds Rate and the Channels of Monetary Transmission," American Economic Review, American Economic Association, vol. 82(4), pages 901-21, September.
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Cited by:
  1. Iwata, Shigeru & Wu, Shu, 2009. "Stock market liberalization and international risk sharing," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 19(3), pages 461-476, July.
  2. Doriana Ruffino & Jonathan Treussard, 2006. "A Study of Inaction in Investment Games via the Early Exercise Premium Representation," Boston University - Department of Economics - Working Papers Series WP2006-040, Boston University - Department of Economics.
  3. Adrien Verdelhan, 2005. "A Habit-Based Explanation of the Exchange Rate Risk Premium," Boston University - Department of Economics - Working Papers Series WP2005-032, Boston University - Department of Economics.
  4. Hanno Lustig & Adrien Verdelhan, 2006. "The Cross-Section of Foreign Currency Risk Premia and Consumption Growth Risk," Boston University - Department of Economics - Working Papers Series WP2006-045, Boston University - Department of Economics.
  5. James R. Lothian & Liuren Wu, 2003. "Uncovered Interest Rate Parity Over the Past Two Centuries," International Finance 0311009, EconWPA.
  6. Kocenda, Evzen & Poghosyan, Tigran, 2009. "Macroeconomic sources of foreign exchange risk in new EU members," Journal of Banking & Finance, Elsevier, vol. 33(11), pages 2164-2173, November.
  7. Katrin Rabitsch, 2014. "An Incomplete Markets Explanation to the UIP Puzzle," Department of Economics Working Papers wuwp171, Vienna University of Economics, Department of Economics.
  8. Hanno Lustig & Adrien Verdelhan, 2005. "The Cross-Section of Currency Risk Premia and US Consumption Growth Risk," NBER Working Papers 11104, National Bureau of Economic Research, Inc.
  9. Hanno Lustig, 2004. "The Cross-Section of Foreign Currency Risk Premia and US Consumption Growth Risk (joint with Adrien Verdelhan)(updated February 2006)," UCLA Economics Online Papers 303, UCLA Department of Economics.
  10. Hanno Lustig & Nikolai Roussanov & Adrien Verdelhan, 2010. "Countercyclical Currency Risk Premia," NBER Working Papers 16427, National Bureau of Economic Research, Inc.
  11. Smith, Peter N & Wickens, Michael R, 2002. "Macroeconomic Sources of FOREX Risk," CEPR Discussion Papers 3148, C.E.P.R. Discussion Papers.
  12. Shu Wu, 2007. "Interest Rate Risk and the Forward Premium Anomaly in Foreign Exchange Markets," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 39(2-3), pages 423-442, 03.

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