Sen Dong () (Finance and Ecnomomics Department Columbia University)
Abstract
Expected exchange rate changes are determined by interest rate differentials across countries and risk premia, while unexpected changes are driven by innovations to macroeconomic variables, which are amplified by time-varying market prices of risk. In a model where short rates respond to the output gap and inflation in each country, I identify macro and monetary policy risk premia by specifying no-arbitrage dynamics of each country's term structure of interest rates and the exchange rate. Estimating the model with US/German data, I find that the correlation between the model-implied exchange rate changes and the data is over 60%. The model implies a countercyclical foreign exchange risk premium with macro risk premia playing an important role in matching the deviations from Uncovered Interest Rate Parity. I find that the output gap and inflation drive about 70% of the variance of forecasting the conditional mean of exchange rate changes
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Publisher Info
Paper provided by Society for Economic Dynamics in its series 2006 Meeting Papers with number
875.
Length: Date of creation: 03 Dec 2006 Date of revision: Handle: RePEc:red:sed006:875
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Find related papers by JEL classification: C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: General - - - Estimation E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Determination of Interest Rates; Term Structure of Interest Rates E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
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