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Exchange Rate Risk and the Macroeconomics of Exchange Rate Determination

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  • Rudiger Dornbusch

Abstract

This paper discusses the link between portfolio diversification models of exchange risk and the macroeconomics of exchange rate determination. A first part sets out the mean-variance model of portfolio choice for the case of two nominal assets with random real returns. From there the model is made "international" by a specification of the world inflation process. The concept of exchange risk is discussed in terms of the variability of the real exchange rate. The paper shows that when all randomness in real returns derives from variability of the real exchange rate, rather than from inflation variability, full hedging is possible. Even for the case of no real exchange rate variability, it is shown, variability of the nominal rate of depreciation is a determinant of the portfolio composition. The risk premium is derived and discussed in terms of the deviation of the anticipated rate of depreciation from the interest differential. The actual rate of depreciation may exceed the interest differential either because of news or because of a risk premium that depends on the relative asset supplies compared to their shares in a minimum variance portfolio. An appendix investigates the implications of tastes and differences and shows that there is an additional component of the premium due to differences in consumption patterns. The portfolio model is integrated In a macro-model to show how the relative supplies of non-monetary assets, through yield and valuation effects, determine the impact and long run consequences of real and nominal monetary disturbances. The integration of the portfolio and macro models relies crucially on the properties of the demand for money. A demand for money that depend. on the average return on securities, rather than on the domestic interest rate, implies that portfolio considerations do not affect exchange rates.

Suggested Citation

  • Rudiger Dornbusch, 1980. "Exchange Rate Risk and the Macroeconomics of Exchange Rate Determination," NBER Working Papers 0493, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:0493
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    References listed on IDEAS

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    1. Fama, Eugene F & Farber, Andre, 1979. "Money, Bonds, and Foreign Exchange," American Economic Review, American Economic Association, vol. 69(4), pages 639-649, September.
    2. Adler, Michael & Dumas, Bernard, 1976. "Portfolio Choice and the Demand for Forward Exchange," American Economic Review, American Economic Association, vol. 66(2), pages 332-339, May.
    3. Frankel, Jeffrey A, 1979. "On the Mark: A Theory of Floating Exchange Rates Based on Real Interest Differentials," American Economic Review, American Economic Association, vol. 69(4), pages 610-622, September.
    4. Dornbusch, Rudiger & Fischer, Stanley, 1980. "Exchange Rates and the Current Account," American Economic Review, American Economic Association, vol. 70(5), pages 960-971, December.
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    Cited by:

    1. Backus, David K. & Kehoe, Patrick J., 1989. "On the denomination of government debt : A critique of the portfolio balance approach," Journal of Monetary Economics, Elsevier, vol. 23(3), pages 359-376, May.
    2. Richard M. Levich, 1983. "Empirical Studies of Exchange Rates: Price Behavior, Rate Determinationand Market Efficiency," NBER Working Papers 1112, National Bureau of Economic Research, Inc.
    3. Jeffrey A. Frankel, 1994. "The Internationalization of Equity Markets," NBER Books, National Bureau of Economic Research, Inc, number fran94-1, March.
    4. Jorge Braga de Macedo & Jeffrey Goldstein & David Meerschwam, 1984. "International Portfolio Diversification: Short-Term Financial Assets and Gold," NBER Chapters, in: Exchange Rate Theory and Practice, pages 199-238, National Bureau of Economic Research, Inc.
    5. Hlongwane, Nyiko Worship, 2022. "The relationship between oil prices and exchange rates in South Africa," MPRA Paper 113209, University Library of Munich, Germany.
    6. Abraham Deka & Behiye Cavusoglu, 2022. "Examining the role of renewable energy on the foreign exchange rate of the OECD economies with dynamic panel GMM and Bayesian VAR model," SN Business & Economics, Springer, vol. 2(9), pages 1-19, September.
    7. Turnovsky, Stephen J., 1985. "Domestic and foreign disturbances in an optimizing model of exchange-rate determination," Journal of International Money and Finance, Elsevier, vol. 4(1), pages 151-171, March.
    8. Carrasco, Alex & Florián, David & Nivín, Rafael, 2019. "SFX Interventions, Financial Intermediation, and External Shocks in Emerging Economies," Working Papers 2019-022, Banco Central de Reserva del Perú.
    9. Frankel, Jeffrey A., 1983. "Estimation of portfolio-balance functions that are mean-variance optimizing : The mark and the dollar," European Economic Review, Elsevier, vol. 23(3), pages 315-327, September.
    10. Loureiro, André Soares & Barbosa, Fernando de Holanda, 2003. "The risk premium on brazilian government debt, 1996-2002," FGV EPGE Economics Working Papers (Ensaios Economicos da EPGE) 485, EPGE Brazilian School of Economics and Finance - FGV EPGE (Brazil).
    11. Rudiger Dornbusch & Daniel Valente Dantas & Clarice Pechman & Roberto de Rezende Rocha & Demetrio Simoes, 1980. "A Model of the Black Market for Dollars," NBER Working Papers 0590, National Bureau of Economic Research, Inc.
    12. Jorge Braga de Macedo, 1982. "Optimal Currency Diversification for a Class of Risk Averse International Investors," NBER Working Papers 0959, National Bureau of Economic Research, Inc.
    13. Belongia, Michael T. & Ott, Mack, 1989. "The US monetary policy regime, interest differentials, and dollar exchange rate risk premia," Journal of International Money and Finance, Elsevier, vol. 8(1), pages 137-145, March.
    14. Mondher Bellalah & Zhen Wu, 2009. "A simple model of corporate international investment under incomplete information and taxes," Annals of Operations Research, Springer, vol. 165(1), pages 123-143, January.
    15. Mondher Bellalah & Shujuan Ding & Zhen Wu, 2012. "Corporate Optimal Investment Under Incomplete Information: A Real Option Method," The Review of Finance and Banking, Academia de Studii Economice din Bucuresti, Romania / Facultatea de Finante, Asigurari, Banci si Burse de Valori / Catedra de Finante, vol. 4(1), pages 007-014, June.
    16. Corinne Winters, 2008. "The Carry Trade, Portfolio Diversification, and the Adjustment of the Japanese Yen," Discussion Papers 08-2, Bank of Canada.
    17. Masahiro Kawai, 1980. "Three roles of the forward foreign exchange market," International Finance Discussion Papers 170, Board of Governors of the Federal Reserve System (U.S.).

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