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Exchange Rate Risk and the Macroeconomics of Exchange Rate Determination


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  • Rudiger Dornbusch


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.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 0493.

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Date of creation: Jun 1980
Date of revision:
Publication status: published as Dornbusch, Rudiger. "Exchange Rate Risk and the Macroeconomics of Exchange Rate Determination." Research in International Business and Finance, Vol. 3, edited by R. Hawkind et al, (1983).
Handle: RePEc:nbr:nberwo:0493

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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 639-49, 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 332-39, 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 610-22, September.
  4. Dornbusch, Rudiger & Fischer, Stanley, 1980. "Exchange Rates and the Current Account," American Economic Review, American Economic Association, vol. 70(5), pages 960-71, December.
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Cited by:
  1. 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.
  2. Michael T. Belongia & Mack Ott, 1987. "The U. S. monetary policy regime, interest differentials and dollar exchange rate risk premia," Working Papers 1987-009, Federal Reserve Bank of St. Louis.
  3. 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.
  4. Jeffrey A. Frankel, 1994. "The Internationalization of Equity Markets," NBER Books, National Bureau of Economic Research, Inc, number fran94-1.
  5. Loureiro, André Soares & Barbosa, Fernando de Holanda, 2003. "The Risk Premium on Brazilian Government Debt, 1996-2002," Economics Working Papers (Ensaios Economicos da EPGE) 485, FGV/EPGE Escola Brasileira de Economia e Finanças, Getulio Vargas Foundation (Brazil).
  6. Corinne Winters, 2008. "The Carry Trade, Portfolio Diversification, and the Adjustment of the Japanese Yen," Discussion Papers 08-2, Bank of Canada.
  7. 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.
  8. Jeffrey A. Frankel, 1981. "Estimation of portfolio-balance functions that are mean-variance optimizing: the mark and the dollar," International Finance Discussion Papers 188, Board of Governors of the Federal Reserve System (U.S.).


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