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On the Foreign-Exchange Risk Premium in Sticky-Price General Equilibrium Models

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  • Charles Engel

Abstract

This paper investigates the behavior of the foreign exchange risk premium in two recent two-country intertemporal-optimizing general equilibrium models with sticky nominal prices: Obstfeld-Rogoff (1998) and Devereux-Engel (1998). The foreign exchange risk premium in any general equilibrium model arises from the correlation of the exchange rate with consumption. In flexible price models, that requires correlation of monetary and output supply shocks. In sticky-price models, the correlation arises endogenously because monetary shocks cause output and consumption to change. The size of the risk premium depends on how prices are set (in producers' currencies versus consumers' currencies), and on the form of the money demand function. In some cases, the risk premium generated by the model is quite large.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 7067.

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Date of creation: Apr 1999
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Publication status: published as Isard, Peter, Assaf Razin and Andrew Rose (eds.) International Finance and Financial Crises: Essays in Honor of Robert P. Flood, Jr. Kluwer Academic Publishers, 1999.
Handle: RePEc:nbr:nberwo:7067

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  1. Engel, Charles, 1996. "The forward discount anomaly and the risk premium: A survey of recent evidence," Journal of Empirical Finance, Elsevier, Elsevier, vol. 3(2), pages 123-192, June.
  2. Bekaert, Geert & Hodrick, Robert J. & Marshall, David A., 1997. "The implications of first-order risk aversion for asset market risk premiums," Journal of Monetary Economics, Elsevier, vol. 40(1), pages 3-39, September.
  3. Maurice Obstfeld & Kenneth Rogoff, 1998. "Risk and Exchange Rates," NBER Working Papers 6694, National Bureau of Economic Research, Inc.
  4. Flood, Robert P & Rose, Andrew K, 1994. "Fixes: Of the Forward Discount Puzzle," CEPR Discussion Papers 1090, C.E.P.R. Discussion Papers.
  5. Charles Engel, 1995. "Accounting for U.S. Real Exchange Rate Changes," NBER Working Papers 5394, National Bureau of Economic Research, Inc.
  6. Obstfeld, Maurice & Rogoff, Kenneth, 1995. "Exchange Rate Dynamics Redux," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 103(3), pages 624-60, June.
  7. Charles Engel, 1990. "On the foreign exchange risk premium in a general equilibrium model," Research Working Paper, Federal Reserve Bank of Kansas City 90-06, Federal Reserve Bank of Kansas City.
  8. Stulz, Rene M, 1984. "Currency Preferences, Purchasing Power Risks, and the Determination of Exchange Rates in an Optimizing Model," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 16(3), pages 302-16, August.
  9. Michael B. Devereux & Charles Engel, 1998. "Fixed vs. Floating Exchange Rates: How Price Setting Affects the Optimal Choice of Exchange-Rate Regime," NBER Working Papers 6867, National Bureau of Economic Research, Inc.
  10. Engel, Charles M., 1984. "Testing for the absence of expected real profits from forward market speculation," Journal of International Economics, Elsevier, vol. 17(3-4), pages 299-308, November.
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