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Exchange rates, expected returns and risk: UIP unbound

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  • Anella Munro

Abstract

No-arbitrage implies a close link between exchange rates and interest returns, but evidence of that link has been elusive. This paper derives an exchange rate asset price model with consumption-risk adjustments. Interest rates and exchange rates reflect common risks which bias their reduced-form relationship. As markets become more complete, the model predicts increasing disconnect between exchange rates and observed interest rates, and between premia that price bonds and premia that price currency returns. When accounting for risk, the estimated interest rate - exchange rate relationship is considerably closer to theory for eight USD currency pairs. Exchange rates, risk and returns need to be jointly modeled.

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  • Anella Munro, 2014. "Exchange rates, expected returns and risk: UIP unbound," CAMA Working Papers 2014-73, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
    • Handle: RePEc:een:camaaa:2014-73
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    Cited by:

    1. Anella Munro, 2015. "Exchange rates, expected returns and risk: what can we learn from Asia-Pacific currencies?," BIS Papers chapters, in: Bank for International Settlements (ed.), Cross-border Financial Linkages: Challenges for Monetary Policy and Financial Stability, volume 82, pages 137-166, Bank for International Settlements.
    2. Anella Munro, 2016. "Bond premia, monetary policy and exchange rate dynamics," Reserve Bank of New Zealand Discussion Paper Series DP2016/11, Reserve Bank of New Zealand.
    3. Yasin Mimir & Enes Sunel, 2015. "External shocks, banks and optimal monetary policy in an open economy," BIS Working Papers 528, Bank for International Settlements.

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    More about this item

    Keywords

    Exchange rate; asset price; risk adjustment; uncovered interest parity; bond premium; currency premium;
    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

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