Equilibrium Exchange Rate Hedging
In a one-period model where each investor consumes a single good, and where borrowing and lending are private and real, there is a universal constant that tells how much each investor hedges his foreign investments. The constant depends only on average risk tolerance across investors. The same constant applies to every real foreign investment held by every investor. Foreign investors are those with different consumption goods, not necessarily those who live in different countries. In equilibrium, the price of the world market portfolio will adjust so that the constant will be related to an average of world market risk premia, an average of world market volatilities, and an average of exchange rate volatilities, where we take the averages over all investors. The constant will not be related to exchange rate means or covariances. In the limiting case when exchange risk approaches zero, the constant will be equal to one minus the ratio of the variance of the world market return to its mean. Jensen's inequality, or "Siegel's paradox," makes investors want significant amounts of exchange rate risk in their portfolios. It also makes investors prefer a world with more exchange rate risk to a similar world with less exchange rate risk.
|Date of creation:||Apr 1989|
|Publication status:||published as Journal of Finance, Vol. 45, no. 3 (1990): 899-908.|
|Contact details of provider:|| Postal: National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.|
Web page: http://www.nber.org
More information through EDIRC
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Mehra, Rajnish & Prescott, Edward C., 1985.
"The equity premium: A puzzle,"
Journal of Monetary Economics,
Elsevier, vol. 15(2), pages 145-161, March.
- R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
- Jeremy J. Siegel, 1972. "Risk, Interest Rates and the Forward Exchange," The Quarterly Journal of Economics, Oxford University Press, vol. 86(2), pages 303-309.
- Frankel, Jeffrey A., 1988. "Recent Estimates of the Time-Variation in the Conditional Variance and in the Exchange Risk Premium," Department of Economics, Working Paper Series qt23c9q73d, Department of Economics, Institute for Business and Economic Research, UC Berkeley.
- Solnik, Bruno H., 1974. "An equilibrium model of the international capital market," Journal of Economic Theory, Elsevier, vol. 8(4), pages 500-524, August.
- Don E. Roper, 1975. "The Role of Expected Value Analysis for Speculative Decisions in the Forward Currency Market," The Quarterly Journal of Economics, Oxford University Press, vol. 89(1), pages 157-169.
- J. Huston McCulloch, 1975. "Operational Aspects of the Siegel Paradox," The Quarterly Journal of Economics, Oxford University Press, vol. 89(1), pages 170-172.
- Frankel, Jeffrey A., 1988. "Recent estimates of time-variation in the conditional variance and in the exchange risk premium," Journal of International Money and Finance, Elsevier, vol. 7(1), pages 115-125, March.
- Jeffrey A. Frankel, 1987. "Recent Estimates of Time-Variation in the Conditional Variance and in the Exchange Risk Premium," NBER Working Papers 2367, National Bureau of Economic Research, Inc.
- Jeffrey A. Frankel., 1988. "Recent Estimates of Time-Variation in the Conditional Variance and in the Exchange Risk Premium," Economics Working Papers 8866, University of California at Berkeley.
- Sebastian Edwards, 1988. "Real Exchange Rate Behavior in Developing Countries: The Cross Country Evidence," UCLA Economics Working Papers 510, UCLA Department of Economics.
- Frankel, Jeffrey A., 1986. "The implications of mean-variance optimization for four questions in international macroeconomics," Journal of International Money and Finance, Elsevier, vol. 5(1, Supple), pages 53-75, March.
- Jeffrey A. Frankel, 1985. "The Implications of Mean-Variance Optimization for Four Questions in International Macroeconomics," NBER Working Papers 1617, National Bureau of Economic Research, Inc.
- Roll, Richard & Solnik, Bruno, 1977. "A pure foreign exchange asset pricing model," Journal of International Economics, Elsevier, vol. 7(2), pages 161-179, May.
- Breeden, Douglas T., 1979. "An intertemporal asset pricing model with stochastic consumption and investment opportunities," Journal of Financial Economics, Elsevier, vol. 7(3), pages 265-296, September.
- Grauer, Frederick L. A. & Litzenberger, Robert H. & Stehle, Richard E., 1976. "Sharing rules and equilibrium in an international capital market under uncertainty," Journal of Financial Economics, Elsevier, vol. 3(3), pages 233-256, June.
- Fischer Black, 1989. "Mean Reversion and Consumption Smoothing," NBER Working Papers 2946, National Bureau of Economic Research, Inc.
- Adler, Michael & Dumas, Bernard, 1983. " International Portfolio Choice and Corporation Finance: A Synthesis," Journal of Finance, American Finance Association, vol. 38(3), pages 925-984, June.
- Taylor, Stephen J., 1987. "Forecasting the volatility of currency exchange rates," International Journal of Forecasting, Elsevier, vol. 3(1), pages 159-170.
- Friend, Irwin & Blume, Marshall E, 1975. "The Demand for Risky Assets," American Economic Review, American Economic Association, vol. 65(5), pages 900-922, December.
- Stulz, ReneM., 1981. "A model of international asset pricing," Journal of Financial Economics, Elsevier, vol. 9(4), pages 383-406, December.
- Paul R. Krugman, 1981. "Consumption Preferences, Asset Demands, and Distribution Effects in International Financial Markets," NBER Working Papers 0651, National Bureau of Economic Research, Inc.
- Eun, Cheol S & Resnick, Bruce G, 1988. " Exchange Rate Uncertainty, Forward Contracts, and International Portfolio Selection," Journal of Finance, American Finance Association, vol. 43(1), pages 197-215, March. Full references (including those not matched with items on IDEAS)
When requesting a correction, please mention this item's handle: RePEc:nbr:nberwo:2947. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: ()
If references are entirely missing, you can add them using this form.