Accounting for Forward Rates in Markets for Foreign Currency
We examine the behavior of forward and spot exchange rates from the perspective of the representative agent theory of asset pricing. We verify that with moderate risk aversion and time-additive preferences the theory accounts for very little (by our calculations, less than 5 percent) of the variability of expected returns from currency speculation observed for major currencies versus the U.S. dollar. With strong habit persistence, however, the theory can account for one-half to two-thirds of the estimated standard deviation of expected returns from currency speculation. Hansen-Jagannathan bounds imply that the variability of expected returns on currencies, like the equity premium, requires a great deal of variability in intertemporal marginal rates of substitution, some of which is delivered by habit persistence.
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