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Exchange Volatility and Risk Premium

Author

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  • Claudio Soto
  • Rodrigo Valdés

Abstract

This paper empirically evaluates the importance of exchange rate regimes and exchange rate volatility on interest rate differentials, with special reference to Chile. We estimate risk-premia for 16 country experiences with different exchange rate regimes and then investigate whether these premia vary with volatility and the regime flexibility. When we assume that any diversifiable risk is actually traded and estimate a CAPM model augmented by taxes, we find a systematic but small relation between exchange rate volatility and risk-premium. In the case of Chile we do not find any significant impact of changes in exchange rate volatility on CAPM-estimated risk-premium. However, when we consider the overall effect of volatility on risk-premium and estimate an ARCH-M model we find a large effect of volatility on risk-premium in this country. In this set-up, when we analyze the cross-country experience, we do not find any relation between regime flexibility and risk-premium.

Suggested Citation

  • Claudio Soto & Rodrigo Valdés, 1999. "Exchange Volatility and Risk Premium," Working Papers Central Bank of Chile 46, Central Bank of Chile.
    • Handle: RePEc:chb:bcchwp:46
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    File URL: https://www.bcentral.cl/documents/33528/133326/DTBC_46.pdf
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    References listed on IDEAS

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    1. Frankel, Jeffrey A. & Rose, Andrew K., 1995. "Empirical research on nominal exchange rates," Handbook of International Economics, in: G. M. Grossman & K. Rogoff (ed.), Handbook of International Economics, edition 1, volume 3, chapter 33, pages 1689-1729, Elsevier.
    2. Bollerslev, Tim & Chou, Ray Y. & Kroner, Kenneth F., 1992. "ARCH modeling in finance : A review of the theory and empirical evidence," Journal of Econometrics, Elsevier, vol. 52(1-2), pages 5-59.
    3. Mussa, Michael, 1986. "Nominal exchange rate regimes and the behavior of real exchange rates: Evidence and implications," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 25(1), pages 117-214, January.
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    Cited by:

    1. Viviana Fernández, 2001. "A Liquidity Premium Puzzle?: Evidence from Chile," Documentos de Trabajo 105, Centro de Economía Aplicada, Universidad de Chile.

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