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The Foreign Exchange Risk Premium: Real and Nominal Factors

  • Hollifield, Burton

    (Carnegie Mellon U)

  • Yaron, Amir

    (U of Pennsylvania)

We estimate the effects of conditional inflation moments on predictable returns available from currency speculation using an arbitrage based model to decompose the risk premium into conditional inflation, real risk, and their interactions. Using two different empirical methods to identify these components, we find that virtually none of the predictable variation in returns from currency speculation can be explained empirically by either conditional inflation risk or the interaction between conditional inflation and real risks. Our results imply that for monetary policy to have significant effects on the risk-premia for currency speculation, monetary policy must have small effect on inflation risk, the relationship between real risk and inflation risk, and instead must mainly impact real exchange rate risk.

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Paper provided by University of Pennsylvania, Wharton School, Weiss Center in its series Working Papers with number 01-1.

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Date of creation: Feb 2001
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Handle: RePEc:ecl:upafin:01-1
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  1. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1985. "A Theory of the Term Structure of Interest Rates," Econometrica, Econometric Society, vol. 53(2), pages 385-407, March.
  2. Bekaert, Geert, 1996. "The Time Variation of Risk and Return in Foreign Exchange Markets: A General Equilibrium Perspective," Review of Financial Studies, Society for Financial Studies, vol. 9(2), pages 427-70.
  3. Obstfeld, Maurice & Rogoff, Kenneth S., 1995. "Exchange Rate Dynamics Redux," Scholarly Articles 12491026, Harvard University Department of Economics.
  4. Ben Bernanke, 1990. "The Federal Funds Rate and the Channels of Monetary Transnission," NBER Working Papers 3487, National Bureau of Economic Research, Inc.
  5. Geert Bekaert & Robert J. Hodrick & David A. Marshall, 1994. "The implications of first-order risk aversion for asset market risk premiums," Working Paper Series, Macroeconomic Issues 94-22, Federal Reserve Bank of Chicago.
  6. John Y. CAMPBELL & Luis VICEIRA, 1998. "Who Should Buy Long-Term Bonds?," FAME Research Paper Series rp5, International Center for Financial Asset Management and Engineering.
  7. Eric M. Leeper & Christopher A. Sims & Tao Zha, 1996. "What Does Monetary Policy Do?," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 27(2), pages 1-78.
  8. David K. Backus & Allan W. Gregory & Chris I. Telmer, 1992. "Accounting for Forward Rates in Markets for Foreign Currency," Working Papers 92-18b, New York University, Leonard N. Stern School of Business, Department of Economics.
  9. Lucas, Robert Jr., 1982. "Interest rates and currency prices in a two-country world," Journal of Monetary Economics, Elsevier, vol. 10(3), pages 335-359.
  10. Strongin, Steven, 1995. "The identification of monetary policy disturbances explaining the liquidity puzzle," Journal of Monetary Economics, Elsevier, vol. 35(3), pages 463-497, June.
  11. Bansal, Ravi, 1997. "An Exploration of the Forward Premium Puzzle in Currency Markets," Review of Financial Studies, Society for Financial Studies, vol. 10(2), pages 369-403.
  12. V. V. Chari & Patrick J. Kehoe & Ellen R. McGrattan, 1997. "Monetary Shocks and Real Exchange Rates in Sticky Price Models of International Business Cycles," NBER Working Papers 5876, National Bureau of Economic Research, Inc.
  13. Engel, Charles & Hamilton, James D, 1990. "Long Swings in the Dollar: Are They in the Data and Do Markets Know It?," American Economic Review, American Economic Association, vol. 80(4), pages 689-713, September.
  14. Bansal, Ravi & Gallant, A. Ronald & Hussey, Robert & Tauchen, George, 1995. "Nonparametric estimation of structural models for high-frequency currency market data," Journal of Econometrics, Elsevier, vol. 66(1-2), pages 251-287.
  15. Charles Engel, 1999. "On the Foreign Exchange Risk Premium in Sticky-Price General Equilibrium Models," International Tax and Public Finance, Springer, vol. 6(4), pages 491-505, November.
  16. David Backus & Silverio Foresi & Chris Telmer, 1996. "Affine Models of Currency Pricing," NBER Working Papers 5623, National Bureau of Economic Research, Inc.
  17. Qiang Dai & Kenneth J. Singleton, 2000. "Specification Analysis of Affine Term Structure Models," Journal of Finance, American Finance Association, vol. 55(5), pages 1943-1978, October.
  18. Baillie, Richard T. & Bollerslev, Tim, 1990. "A multivariate generalized ARCH approach to modeling risk premia in forward foreign exchange rate markets," Journal of International Money and Finance, Elsevier, vol. 9(3), pages 309-324, September.
  19. Canova, Fabio & Marrinan, Jane, 1993. "Profits, risk, and uncertainty in foreign exchange markets," Journal of Monetary Economics, Elsevier, vol. 32(2), pages 259-286, November.
  20. Charles Engel, 1995. "The Forward Discount Anomaly and the Risk Premium: A Survey of Recent Evidence," NBER Working Papers 5312, National Bureau of Economic Research, Inc.
  21. Baillie, Richard T. & Bollerslev, Tim, 2000. "The forward premium anomaly is not as bad as you think," Journal of International Money and Finance, Elsevier, vol. 19(4), pages 471-488, August.
  22. Hansen, Lars Peter, 1982. "Large Sample Properties of Generalized Method of Moments Estimators," Econometrica, Econometric Society, vol. 50(4), pages 1029-54, July.
  23. Lewis, Karen K, 1989. "Changing Beliefs and Systematic Rational Forecast Errors with Evidence from Foreign Exchange," American Economic Review, American Economic Association, vol. 79(4), pages 621-36, September.
  24. repec:dgr:kubcen:199707 is not listed on IDEAS
  25. Bekaert, Geert, 1994. "Exchange rate volatility and deviations from unbiasedness in a cash-in-advance model," Journal of International Economics, Elsevier, vol. 36(1-2), pages 29-52, February.
  26. Fama, Eugene F., 1984. "Forward and spot exchange rates," Journal of Monetary Economics, Elsevier, vol. 14(3), pages 319-338, November.
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