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Foreign exchange rate risk in a small open economy

Author

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  • De Paoli, Bianca

    () (Bank of England)

  • Sondergaard, Jens

    () (Bank of England)

Abstract

Resolving the forward premium puzzle requires a volatile foreign exchange rate risk premium that covaries negatively with the expected depreciation rate. Earlier work has shown how models featuring consumption habits can generate such premia when either trade costs or 'deep habits' are assumed. We show that as long as consumption habits are slow-moving and shocks are highly persistent, a standard small open endowment economy - without any additional features - can address the puzzle. Moreover endogenising the labour supply decision in the small open economy can improve the model's ability to match risk premia observations so long as it makes business cycles less synchronised.

Suggested Citation

  • De Paoli, Bianca & Sondergaard, Jens, 2009. "Foreign exchange rate risk in a small open economy," Bank of England working papers 365, Bank of England.
  • Handle: RePEc:boe:boeewp:0365
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    References listed on IDEAS

    as
    1. De Paoli, Bianca & Zabczyk, Pawel, 2012. "Why Do Risk Premia Vary Over Time? A Theoretical Investigation Under Habit Formation," Macroeconomic Dynamics, Cambridge University Press, vol. 16(S2), pages 252-266, September.
    2. V. V Chari & Patrick J. Kehoe & Ellen R. McGrattan, 2002. "Can Sticky Price Models Generate Volatile and Persistent Real Exchange Rates?," Review of Economic Studies, Oxford University Press, vol. 69(3), pages 533-563.
    3. Sarno,Lucio & Taylor,Mark P., 2003. "The Economics of Exchange Rates," Cambridge Books, Cambridge University Press, number 9780521485845, April.
    4. S. Rao Aiyagari, 1994. "Uninsured Idiosyncratic Risk and Aggregate Saving," The Quarterly Journal of Economics, Oxford University Press, vol. 109(3), pages 659-684.
    5. De Paoli, Bianca, 2009. "Monetary policy and welfare in a small open economy," Journal of International Economics, Elsevier, vol. 77(1), pages 11-22, February.
    6. Moore, Michael J. & Roche, Maurice J., 2010. "Solving exchange rate puzzles with neither sticky prices nor trade costs," Journal of International Money and Finance, Elsevier, vol. 29(6), pages 1151-1170, October.
    7. Adrien Verdelhan, 2010. "A Habit-Based Explanation of the Exchange Rate Risk Premium," Journal of Finance, American Finance Association, vol. 65(1), pages 123-146, February.
    8. Pasquale Della Corte & Lucio Sarno & Ilias Tsiakas, 2009. "An Economic Evaluation of Empirical Exchange Rate Models," Review of Financial Studies, Society for Financial Studies, vol. 22(9), pages 3491-3530, September.
    9. Rudebusch, Glenn D. & Swanson, Eric T., 2008. "Examining the bond premium puzzle with a DSGE model," Journal of Monetary Economics, Elsevier, vol. 55(Supplemen), pages 111-126, October.
    10. Bacchetta, Philippe & van Wincoop, Eric, 2005. "Rational Inattention: A Solution to the Forward Discount Puzzle," CEPR Discussion Papers 5261, C.E.P.R. Discussion Papers.
    11. Andrew B. Abel, 2006. "Equity Premia with Benchmark Levels of Consumption: Closed-Form Results," NBER Working Papers 12290, National Bureau of Economic Research, Inc.
    Full references (including those not matched with items on IDEAS)

    Citations

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    Cited by:

    1. Heipertz, Jonas & Mihov, Ilian & Santacreu, Ana Maria, 2017. "The Exchange Rate as an Instrument of Monetary Policy," Working Papers 2017-28, Federal Reserve Bank of St. Louis.
    2. repec:cuf:journl:y:2017:v:18:i:1:asab is not listed on IDEAS
    3. Vít Pošta, 2012. "Estimation of the Time-Varying Risk Premium in the Czech Foreign Exchange Market," Prague Economic Papers, University of Economics, Prague, vol. 2012(1), pages 3-17.
    4. Groth, Charlotta & Zampolli, Fabrizio, 2010. "Macroeconomic stability and the real interest rate: a cross-country analysis," Discussion Papers 30, Monetary Policy Committee Unit, Bank of England.

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