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Currency Risk and Imperfect Knowledge: Volatility and Long Swings around Benchmark Values

Listed author(s):
  • Josh Stillwagon

    ()

    (Department of Economics, Trinity College)

This study tests several models of the currency risk premium, but does so using survey data on traders' forecasts to directly measure the expected excess return. Among those tested are UIP, CAPM, and the Imperfect Knowledge Economics (IKE) gap model, which respectively imply that the premium is zero, related to the variance of the exchange rate, and related to the deviation between the exchange rate and its benchmark value of Purchasing Power Parity (PPP). The main result is that the p-value testing the restrictions of the models is between .26-.61 greater for the IKE model than for the traditional models. An effect of the volatility can be detected, but primarily in the short-run dynamics and only after controlling for the gap effect of how far the exchange rate is from PPP. This suggests that the difficulty in the previous literature to find the hypothesized effect of volatility was, in part, an omitted variable bias.

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File URL: http://internet2.trincoll.edu/repec/WorkingPapers2013/WP13-15.pdf
File Function: First version, 2013
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Paper provided by Trinity College, Department of Economics in its series Working Papers with number 1315.

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Length: 42 pages
Date of creation: Dec 2013
Handle: RePEc:tri:wpaper:1315
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Web page: http://www.trincoll.edu/Academics/MajorsAndMinors/Economics/Pages/default.aspx

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  1. Kenneth A. Froot & Jeffrey A. Frankel, 1989. "Forward Discount Bias: Is it an Exchange Risk Premium?," The Quarterly Journal of Economics, Oxford University Press, vol. 104(1), pages 139-161.
  2. Tversky, Amos & Kahneman, Daniel, 1992. "Advances in Prospect Theory: Cumulative Representation of Uncertainty," Journal of Risk and Uncertainty, Springer, vol. 5(4), pages 297-323, October.
  3. Kilian, Lutz & Taylor, Mark P., 2003. "Why is it so difficult to beat the random walk forecast of exchange rates?," Journal of International Economics, Elsevier, vol. 60(1), pages 85-107, May.
  4. Henrik Hansen & Søren Johansen, 1999. "Some tests for parameter constancy in cointegrated VAR-models," Econometrics Journal, Royal Economic Society, vol. 2(2), pages 306-333.
  5. J. Tobin, 1958. "Liquidity Preference as Behavior Towards Risk," Review of Economic Studies, Oxford University Press, vol. 25(2), pages 65-86.
  6. Alan M. Taylor & Mark P. Taylor, 2004. "The Purchasing Power Parity Debate," Journal of Economic Perspectives, American Economic Association, vol. 18(4), pages 135-158, Fall.
  7. De Long, J Bradford & Andrei Shleifer & Lawrence H. Summers & Robert J. Waldmann, 1990. "Noise Trader Risk in Financial Markets," Journal of Political Economy, University of Chicago Press, vol. 98(4), pages 703-738, August.
  8. 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.
  9. Engle, Robert & Granger, Clive, 2015. "Co-integration and error correction: Representation, estimation, and testing," Applied Econometrics, Publishing House "SINERGIA PRESS", vol. 39(3), pages 106-135.
  10. Cavaglia, Stefano & Verschoor, Willem F. C. & Wolff, Christian C. P., 1993. "Further evidence on exchange rate expectations," Journal of International Money and Finance, Elsevier, vol. 12(1), pages 78-98, February.
  11. Jeremy J. Siegel & Richard H. Thaler, 1997. "Anomalies: The Equity Premium Puzzle," Journal of Economic Perspectives, American Economic Association, vol. 11(1), pages 191-200, Winter.
  12. Kahneman, Daniel & Tversky, Amos, 1979. "Prospect Theory: An Analysis of Decision under Risk," Econometrica, Econometric Society, vol. 47(2), pages 263-291, March.
  13. Chinn, Menzie & Frankel, Jeffrey, 1994. "Patterns in Exchange Rate Forecasts for Twenty-five Currencies," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 26(4), pages 759-770, November.
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