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The Consumption - Real Exchange Rate Anomaly: an Asset Pricing Perspective

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  • Mathias Hoffmann
  • Thomas Nitschka

Abstract

Idiosyncratic consumption risk explains more than 60 percent of the cross-sectional variation in quarterly exchange rate changes and currency returns. Our results are obtained from data of 13 industrialized countries and are based on an international version of the consumption capital asset pricing model (CCAPM) in which we account for international consumption heterogeneity. We use this framework to dissect the consumption-exchange rate anomaly, the empirical fact that international variation in purchasing power alone does not appear to account for differences in consumption growth rates across countries. As an explanation for this phenomenon, we explore the presence of currency risk premia that also lead to departures from uncovered interest parity (UIP). We decompose the cross-sectional variation in consumption into one component that is due to cross-country differences in inflation rates and a second component that is due to international variation in nominal interest rates. We interpret these factors as indicators of goods and financial market segmentation respectively. We find that both help account to virtually equal parts for the cross-section of exchange rate changes. Interestingly, the price of aggregate consumption risk has declined over the 1990s, in line with a growing literature that documents a growing internationalisation of country portfolios over this period.

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Bibliographic Info

Paper provided by Institute for Empirical Research in Economics - University of Zurich in its series IEW - Working Papers with number 331.

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Date of creation: Sep 2007
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Handle: RePEc:zur:iewwpx:331

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Keywords: Uncovered interest rate parity; consumption CAPM; international financial integration; consumption risk sharing;

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  1. Robert Kollmann, 1995. "Consumption, real exchange rates and the structure of international asset markets," ULB Institutional Repository 2013/7642, ULB -- Universite Libre de Bruxelles.
  2. Ravn, Morten O., 2001. "Consumption Dynamics and Real Exchange Rate," CEPR Discussion Papers 2940, C.E.P.R. Discussion Papers.
  3. Lustig, H. & Verdelhan, A., 2006. "The Cross-Section of Foreign Currency Risk Premia and Consumption Growth Risk," Working papers 155, Banque de France.
  4. Sergei Sarkissian, 2003. "Incomplete Consumption Risk Sharing and Currency Risk Premiums," Review of Financial Studies, Society for Financial Studies, vol. 16(3), pages 983-1005, July.
  5. Shanken, Jay, 1992. "On the Estimation of Beta-Pricing Models," Review of Financial Studies, Society for Financial Studies, vol. 5(1), pages 1-33.
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