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Explaining exchange rate dynamics - the uncovered equity return parity condition

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Author Info
Elizaveta Krylova () (European Central Bank, Market Operations, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany)
Lorenzo Cappiello () (DG-Research, European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany)
Roberto A. De Santis () (DG Economics, European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany)

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Abstract

By employing Lucas’ (1982) model, this study proposes an arbitrage relationship – the Uncovered Equity Return Parity (URP) condition – to explain the dynamics of exchange rates. When expected equity returns in a country/region are lower than expected equity returns in another country/region, the currency associated with the market offering lower returns is expected to appreciate. First, we test the URP assuming that investors are risk neutral and next we relax this hypothesis. The resulting risk premia are proxied by economic variables, which are related to the business cycle. We employ differentials in corporate earnings’ growth rates, short-term interest rate changes, annual inflation rates, and net equity flows. The URP explains a large fraction of the variability of some European currencies vis-à-vis the US dollar. When confronted with the naïve random walk model, the URP for the EUR/USD performs better in terms of forecasts for a set of alternative statistics.

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Paper provided by European Central Bank in its series Working Paper Series with number 529.

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Length: 44 pages
Date of creation: Sep 2005
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Handle: RePEc:ecb:ecbwps:20050529

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Related research
Keywords: Foreign exchange markets asset pricing random walk UIP GMM.

Find related papers by JEL classification:
F31 - International Economics - - International Finance - - - Foreign Exchange
G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models
C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Other Model Applications

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References listed on IDEAS
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Enzo Weber, 2007. "Who Leads Financial Markets?," SFB 649 Discussion Papers SFB649DP2007-015, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany. [Downloadable!]
    Other versions:
  2. Harald Hau & Helene Rey, 2008. "Global Portfolio Rebalancing Under the Microscope," NBER Working Papers 14165, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  3. Lorenzo Cappiello & Roberto A. De Santis, 2007. "The uncovered return parity condition," Working Paper Series 812, European Central Bank. [Downloadable!]
  4. Michael Fidora & Marcel Fratzscher & Christian Thimann, 2006. "Home bias in global bond and equity markets - the role of real exchange rate volatility," Working Paper Series 685, European Central Bank. [Downloadable!]
    Other versions:
  5. Enzo Weber, 2007. "Volatility and Causality in Asia Pacific Financial Markets," SFB 649 Discussion Papers SFB649DP2007-004, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany. [Downloadable!]
  6. Bonpasse, Morrison, 2006. "The Single Global Currency: Common Cents for the World," MPRA Paper 1175, University Library of Munich, Germany. [Downloadable!]
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