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A Theory of Exchange Rates and the Term Structure of Interest Rates

  • Masao Ogaki


The purpose of this paper is to construct a model of exchange rate determination that is consistent with the stylized facts regarding the uncovered interest parity for short term and long term interest rates. This task is especially challenging because of the forward premium anomaly found for short term interest rates and forward exchange rates. With an assumption that investors have a short investment horizon, the model is consistent with these stylized facts even when the degree of risk aversion is low. The model predicts a complicated relationship between exchange rates and the term structure of the interest rates.

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Paper provided by Ohio State University, Department of Economics in its series Working Papers with number 99-19.

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Date of creation: Dec 1999
Date of revision:
Handle: RePEc:osu:osuewp:99-19
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  1. Baxter, Marianne, 1994. "Real exchange rates and real interest differentials: Have we missed the business-cycle relationship?," Journal of Monetary Economics, Elsevier, vol. 33(1), pages 5-37, February.
  2. Fama, Eugene F., 1984. "Forward and spot exchange rates," Journal of Monetary Economics, Elsevier, vol. 14(3), pages 319-338, November.
  3. Guy Meredith & Menzie D. Chinn, 1998. "Long-Horizon Uncovered Interest Rate Parity," NBER Working Papers 6797, National Bureau of Economic Research, Inc.
  4. Masao Ogaki & Young Hwan Byeon, 1999. "A Empirical Investigation of Exchange Rates and the Term Structure of Interest Rates," Working Papers 99-20, Ohio State University, Department of Economics.
  5. Popper, Helen, 1993. "Long-term covered interest parity: evidence from currency swaps," Journal of International Money and Finance, Elsevier, vol. 12(4), pages 439-448, August.
  6. Hyoung-Seok Lim & Masao Ogaki, 2003. "A Theory of Exchange Rates and the Term Structure of Interest Rates," RCER Working Papers 504, University of Rochester - Center for Economic Research (RCER).
  7. Meese, R. & Rogoff, K., 1988. "Was It Real? The Exchange Rate-Interest Differential Ralation Over The Modern Floating-Rate Period," Working papers 368, Wisconsin Madison - Social Systems.
  8. Bennett T. McCallum, 1992. "A Reconsideration of the Uncovered Interest Parity Relationship," NBER Working Papers 4113, National Bureau of Economic Research, Inc.
  9. Richard H. Clarida & Mark P. Taylor, 1997. "The Term Structure Of Forward Exchange Premiums And The Forecastability Of Spot Exchange Rates: Correcting The Errors," The Review of Economics and Statistics, MIT Press, vol. 79(3), pages 353-361, August.
  10. David K. Backus, 2001. "Affine Term Structure Models and the Forward Premium Anomaly," Journal of Finance, American Finance Association, vol. 56(1), pages 279-304, 02.
  11. Frankel, Jeffrey A, 1979. "On the Mark: A Theory of Floating Exchange Rates Based on Real Interest Differentials," American Economic Review, American Economic Association, vol. 69(4), pages 610-22, September.
  12. Engel, Charles, 1996. "The forward discount anomaly and the risk premium: A survey of recent evidence," Journal of Empirical Finance, Elsevier, vol. 3(2), pages 123-192, June.
  13. Mark, Nelson C, 1995. "Exchange Rates and Fundamentals: Evidence on Long-Horizon Predictability," American Economic Review, American Economic Association, vol. 85(1), pages 201-18, March.
  14. Alexius, Annika, 2001. "Uncovered Interest Parity Revisited," Review of International Economics, Wiley Blackwell, vol. 9(3), pages 505-17, August.
  15. Blanchard, Olivier J & Plantes, Mary Kay, 1977. "A Note on Gross Substitutability of Financial Assets," Econometrica, Econometric Society, vol. 45(3), pages 769-71, April.
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