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Are Risk Premia Related to Real Exchange Rate Swings? Survey Expectations and I(2) Trends

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  • Josh Stillwagon

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    (Department of Economics, Trinity College)

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    Abstract

    This paper tests the ex ante implications of Frydman and Goldberg's Imperfect Knowledge Economics (IKE) gap model in such a way as to overcome the endogeneity bias and data restrictions of previous work. The IKE gap model relates the expected excess return (measured here through survey data for three exchange rates) to the deviation or "gap" between the exchange rate and its benchmark value, proxied with Purchasing Power Parity. Strong support is found for this hypothesis in a Polynomially (I(2)) Cointegrated VAR analysis. This statistical framework more adequately addresses non-stationarity and provides a better examination of the driving and adjustment dynamics. Evidence of persistent changes, or near I(2) behavior, is found for several variables including relative interest rates and prices, as well as for the real exchange rate in some instances, which is contrary to REH theory but consistent with the IKE theory.

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    File URL: http://internet2.trincoll.edu/repec/WorkingPapers2013/WP13-18.pdf
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    Bibliographic Info

    Paper provided by Trinity College, Department of Economics in its series Working Papers with number 1318.

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    Length: 27 pages
    Date of creation: Dec 2013
    Date of revision:
    Handle: RePEc:tri:wpaper:1318

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    Keywords: Time-varying risk premium; survey data; polynomial cointegration; I(2); real exchange rate swings; imperfect knowledge economics gap model; prospect theory;

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    1. Johansen, Soren, 1988. "Statistical analysis of cointegration vectors," Journal of Economic Dynamics and Control, Elsevier, vol. 12(2-3), pages 231-254.
    2. Taylor, Alan M & Taylor, Mark P, 2004. "The Purchasing Power Parity Debate," CEPR Discussion Papers 4495, C.E.P.R. Discussion Papers.
    3. Froot, Kenneth A & Frankel, Jeffrey A, 1989. "Forward Discount Bias: Is It an Exchange Risk Premium?," The Quarterly Journal of Economics, MIT Press, vol. 104(1), pages 139-61, February.
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    16. Juselius, Katarina, 2006. "The Cointegrated VAR Model: Methodology and Applications," OUP Catalogue, Oxford University Press, number 9780199285679, September.
    17. Jeremy J. Siegel & Richard H. Thaler, 1997. "Anomalies: The Equity Premium Puzzle," Journal of Economic Perspectives, American Economic Association, vol. 11(1), pages 191-200, Winter.
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