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Exchange Rate Risk and Business Cycles

Author

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  • Lloyd, S. P.
  • Marin, E. A.

Abstract

We show that currencies with a steeper yield curve depreciate at business-cycle horizons. We identify a tent-shaped relationship between exchange-rate risk premia (ERRP) and the relative yield curve slope across horizons that peaks at 3-5 years and is robust to a number of controls, including liquidity yields. Within a no-arbitrage framework, ERRP reflect investors' changing return valuations over the business cycle. We calibrate a two-country, two-factor model of interest rates, where exchange rates are driven by business-cycle - transitory and cyclical - risk. The model quantitatively reproduces the tent-shaped relationship, as well as variation in uncovered interest parity coefficients across horizons.

Suggested Citation

  • Lloyd, S. P. & Marin, E. A., 2019. "Exchange Rate Risk and Business Cycles," Cambridge Working Papers in Economics 1996, Faculty of Economics, University of Cambridge.
    • Handle: RePEc:cam:camdae:1996
    Note: eam65
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    References listed on IDEAS

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    Cited by:

    1. Giancarlo Corsetti & Emile A. Marin, 2020. "A century of arbitrage and disaster risk pricing in the foreign exchange market," Discussion Papers 2018, Centre for Macroeconomics (CFM).
    2. Ostry, D. A., 2023. "Tails of Foreign Exchange-at-Risk (FEaR)," Janeway Institute Working Papers 2311, Faculty of Economics, University of Cambridge.
    3. Pierre Olivier Gourinchas, 2023. "International Macroeconomics: From the Great Financial Crisis to COVID-19, and Beyond," IMF Economic Review, Palgrave Macmillan;International Monetary Fund, vol. 71(1), pages 1-34, March.

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    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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