Accounting for Forward Rates in Markets for Foreign Currency
AbstractWe examine the behavior of forward and spot exchange rates from the perspective of the representative agent theory of asset pricing. We verify that with moderate risk aversion and time-additive preferences the theory accounts for very little (by our calculations, less than 5 percent) of the variability of expected returns from currency speculation observed for major currencies versus the U.S. dollar. With strong habit persistence, however, the theory can account for one-half to two-thirds of the estimated standard deviation of expected returns from currency speculation. Hansen-Jagannathan bounds imply that the variability of expected returns on currencies, like the equity premium, requires a great deal of variability in intertemporal marginal rates of substitution, some of which is delivered by habit persistence.
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Bibliographic InfoPaper provided by Queen's University, Department of Economics in its series Working Papers with number 792.
Date of creation: Jul 1990
Date of revision:
forward and spot rates; risk premiums; contingent claims pricing; habit persistence; marginal rate of substitution;
Other versions of this item:
- Backus, David K & Gregory, Allan W & Telmer, Chris I, 1993. " Accounting for Forward Rates in Markets for Foreign Currency," Journal of Finance, American Finance Association, vol. 48(5), pages 1887-1908, December.
- David K. Backus & Allan W. Gregory & Chris I. Telmer, 1992. "Accounting for Forward Rates in Markets for Foreign Currency," Working Papers 92-18b, New York University, Leonard N. Stern School of Business, Department of Economics.
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