Hot Tip: Nominal Exchange Rates and Inflation Indexed Bond Yields
This paper derives a structural relationship between the nominal exchange rate, national price levels, and observed yields on long maturity inflation - indexed bonds. This relationship can be interpreted as defining the fair value of the exchange rate that will prevail in any model or real world economy in which inflation indexed bonds are traded. An advantage of our derivation is that it does not require restrictive assumptions on financial market equilibrium to be operational. We take our theory to a dataset spanning the period January 2001 - February 2011 and study a daily , real time decompositions of pound, euro, and yen exchange rates into their fair value and risk premium components. The relative importance of these two factors varies depending on the sub sample studied. However, sub samples in which we find correlations of 0.30 to 0.60 between daily exchange rate changes and daily changes in fair value are not uncommon. We also show empirically and justify theoretically that a 1 percent rise in the foreign currency risk premium is on average contemporaneously associated with a 50 basis point rise in the inflation indexed bond return differential in favor of the foreign country and an 50 basis point appreciation of the dollar
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