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Exchange rates, expected returns and risk

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Abstract

According to theory, higher expected foreign risk-free returns and foreign currency risk both increase foreign yields, but have opposing effects on the value of the foreign currency. This paper exploits that relationship to jointly identify the unobserved risk-free return and risk premium components of exchange rates and expected relative returns. When risk and return are jointly modelled over a 10-year horizon, UIP cannot be rejected for any of the eight advanced country USD currency pairs examined. Innovations in the currency premium are correlated with 'speculative' positioning in foreign exchange markets, and for non-reserve currencies, with 'VIX' risk aversion. Innovations in the risk-free component are correlated with changes in nominal short-term interest rates. Both expected returns and risk play important roles in exchange rate dynamics.

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  • Anella Munro, 2014. "Exchange rates, expected returns and risk," Reserve Bank of New Zealand Discussion Paper Series DP2014/01, Reserve Bank of New Zealand.
  • Handle: RePEc:nzb:nzbdps:2014/01
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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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    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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