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A Habit-Based Explanation of the Exchange Rate Risk Premium

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  • Adrien Verdelhan

    (Department of Economics, Boston University)

Abstract

This paper presents a fully rational general equilibrium model that produces a time- varying exchange rate risk premium and solves the uncovered interest rate parity (U.I.P) puzzle. In this two-country model, agents are characterized by slow-moving external habit preferences derived from Campbell & Cochrane (1999). Endowment shocks are i.i.d and real risk-free rates are time-varying. Agents can trade across countries, but when a unit is shipped, only a fraction of the good arrives to the foreign shore. The model gives a rationale for the U.I.P puzzle: the domestic investor receives a positive exchange rate risk premium when she is more risk-averse than her foreign counterpart. Times of high risk- aversion correspond to low interest rates. Thus, the domestic investor receives a positive risk premium when interest rates are lower at home than abroad. The model is both simulated and estimated. The simulation recovers the usual negative coefficient between exchange rate variations and interest rate differentials. When the iceberg-like trade cost is taken into account, the exchange rate variance produced is in line with its empirical counterpart. A nonlinear estimation of the model using consumption data leads to reasonable parameters when pricing the foreign excess returns of an American investor.

Suggested Citation

  • Adrien Verdelhan, 2005. "A Habit-Based Explanation of the Exchange Rate Risk Premium," Boston University - Department of Economics - Working Papers Series WP2005-032, Boston University - Department of Economics.
  • Handle: RePEc:bos:wpaper:wp2005-032
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    More about this item

    Keywords

    Exchange rate; Time-varying risk premium; Habits;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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