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The Foreign Exchange Risk Premium: Real and Nominal Factors

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Author Info

  • Hollifield, B.
  • Yaron, A.

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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Bibliographic Info

Paper provided by Carnegie Mellon University, Tepper School of Business in its series GSIA Working Papers with number 1999-17.

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Length: 38 pages
Date of creation: 1999
Date of revision:
Handle: RePEc:cmu:gsiawp:1999-17

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Postal: Tepper School of Business, Carnegie Mellon University, 5000 Forbes Avenue, Pittsburgh, PA 15213-3890
Web page: http://www.tepper.cmu.edu/

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Web: http://student-3k.tepper.cmu.edu/gsiadoc/GSIA_WP.asp

Related research

Keywords: INFLATION ; EXCHANGE RATE ; RISK;

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References

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  1. Viceira, Luis & Campbell, John, 2001. "Who Should Buy Long-Term Bonds?," Scholarly Articles 3128709, Harvard University Department of Economics.
  2. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1985. "A Theory of the Term Structure of Interest Rates," Econometrica, Econometric Society, vol. 53(2), pages 385-407, March.
  3. Lucas, Robert Jr., 1982. "Interest rates and currency prices in a two-country world," Journal of Monetary Economics, Elsevier, vol. 10(3), pages 335-359.
  4. Eric M. Leeper & Christopher A. Sims & Tao Zha, 1996. "What Does Monetary Policy Do?," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 27(2), pages 1-78.
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  7. 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.
  8. Geert Bekaert & Robert J. Hodrick & David A. Marshall, 1994. "The implications of first-order risk aversion for asset market risk premiums," Working Paper Series, Macroeconomic Issues 94-22, Federal Reserve Bank of Chicago.
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  10. Charles Engel, 1999. "On the Foreign Exchange Risk Premium in Sticky-Price General Equilibrium Models," International Tax and Public Finance, Springer, vol. 6(4), pages 491-505, November.
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  17. V. V. Chari & Patrick J. Kehoe & Ellen R. McGrattan, 1997. "Monetary Shocks and Real Exchange Rates in Sticky Price Models of International Business Cycles," NBER Working Papers 5876, National Bureau of Economic Research, Inc.
  18. David K. Backus & Allan W. Gregory & Chris I. Telmer, 1990. "Accounting for Forward Rates in Markets for Foreign Currency," Working Papers 792, Queen's University, Department of Economics.
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Citations

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Cited by:
  1. Hanno Lustig & Adrien Verdelhan, 2007. "The Cross Section of Foreign Currency Risk Premia and Consumption Growth Risk," American Economic Review, American Economic Association, vol. 97(1), pages 89-117, March.
  2. Shu Wu, 2005. "Interest Rate Risk and the Forward Premium Anomaly in Foreign Exchange Markets," WORKING PAPERS SERIES IN THEORETICAL AND APPLIED ECONOMICS 200519, University of Kansas, Department of Economics, revised Oct 2005.
  3. Adrien Verdelhan, 2006. "A Habit-Based Explanation of the Exchange Rate Risk Premium," 2006 Meeting Papers 872, Society for Economic Dynamics.
  4. Mike R Wickens & Peter N Smith, . "Macroeconmic Sources of FOREX Risk," Discussion Papers 01/13, Department of Economics, University of York.
  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. 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.
  8. Katrin Rabitsch, 2014. "An Incomplete Markets Explanation to the UIP Puzzle," Department of Economics Working Papers wuwp171, Vienna University of Economics, Department of Economics.
  9. 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.
  10. 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.
  11. Lustig, Hanno & Roussanov, Nikolai & Verdelhan, Adrien, 2014. "Countercyclical currency risk premia," Journal of Financial Economics, Elsevier, vol. 111(3), pages 527-553.
  12. 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.

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