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The Effect of Risk on Interest Rates: A Synthesis of the Macroeconomic and Financial Views

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  • Pentti J.K. Kouri
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    Abstract

    This paper analyzes the effects of real income and price level uncertainty on equilibrium interest rates. It is demonstrated that even if there are no outside nominal assets, the interest rate on nominal bonds contains a risk premium, or as the case may be, a risk discount. The sign, and the magnitude, of the deviation from the Fisher parity depends on the covariance between the purchasing power of money on the one hand and real income on the other. The second part of the paper extends the model into a model of two countries, two monies and two bonds denominated in these two monies. It is shown, in contrast with statements made in the literature, that the 'efficiency' of international financial markets does not imply equality of expected real interest rates on bonds denominated in different currencies, nor does it imply that the forward exchange rate should be an unbiased predictor of the future spot exchange rate. This is again true even when there are no outside nominal assets in the world economy.

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    File URL: http://www.nber.org/papers/w0643.pdf
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    Bibliographic Info

    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 0643.

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    Date of creation: Mar 1981
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    Publication status: published as Kouri, Pentti J.K. "The Effect of Risk on Interest Rates: A Synthesis of the macroeconomic and Financial Views." Research in International Business & Finance: A research Annual. The Internationalization of Financial Markets & National Economic Policy, ed. by R.G. Hawkins & R.M. Levich, Vol. 3, 1983.
    Handle: RePEc:nbr:nberwo:0643

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    1. Pentti J.K. Kouri & Jorge B. de Macedo, 1978. "Exchange Rates and the International Adjustment Process," Cowles Foundation Discussion Papers, Cowles Foundation for Research in Economics, Yale University 488, Cowles Foundation for Research in Economics, Yale University.
    2. Grauer, Frederick L. A. & Litzenberger, Robert H. & Stehle, Richard E., 1976. "Sharing rules and equilibrium in an international capital market under uncertainty," Journal of Financial Economics, Elsevier, Elsevier, vol. 3(3), pages 233-256, June.
    3. Fama, Eugene F & Farber, Andre, 1979. "Money, Bonds, and Foreign Exchange," American Economic Review, American Economic Association, American Economic Association, vol. 69(4), pages 639-49, September.
    4. Adler, Michael & Dumas, Bernard, 1976. "Portfolio Choice and the Demand for Forward Exchange," American Economic Review, American Economic Association, American Economic Association, vol. 66(2), pages 332-39, May.
    5. Frankel, Jeffrey A., 1979. "The diversifiability of exchange risk," Journal of International Economics, Elsevier, Elsevier, vol. 9(3), pages 379-393, August.
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