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Are Risk Premia Related to Real Exchange Rate Swings? Survey Expectations and I(2) Trends

  • Josh Stillwagon

    ()

    (Department of Economics, Trinity College)

This paper tests the ex ante implications of Frydman and Goldberg's Imperfect Knowledge Economics (IKE) gap model in such a way as to overcome the endogeneity bias and data restrictions of previous work. The IKE gap model relates the expected excess return (measured here through survey data for three exchange rates) to the deviation or "gap" between the exchange rate and its benchmark value, proxied with Purchasing Power Parity. Strong support is found for this hypothesis in a Polynomially (I(2)) Cointegrated VAR analysis. This statistical framework more adequately addresses non-stationarity and provides a better examination of the driving and adjustment dynamics. Evidence of persistent changes, or near I(2) behavior, is found for several variables including relative interest rates and prices, as well as for the real exchange rate in some instances, which is contrary to REH theory but consistent with the IKE theory.

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File URL: http://internet2.trincoll.edu/repec/WorkingPapers2013/WP13-18.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 1318.

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Length: 27 pages
Date of creation: Dec 2013
Date of revision:
Handle: RePEc:tri:wpaper:1318
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Web page: http://www.trincoll.edu/Academics/MajorsAndMinors/Economics/Pages/default.aspx

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  1. Alan M. Taylor & Mark P. Taylor, 2004. "The Purchasing Power Parity Debate," NBER Working Papers 10607, National Bureau of Economic Research, Inc.
  2. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-76, December.
  3. Benartzi, Shlomo & Thaler, Richard H, 1995. "Myopic Loss Aversion and the Equity Premium Puzzle," The Quarterly Journal of Economics, MIT Press, vol. 110(1), pages 73-92, February.
  4. J. Bradford De Long & Andrei Shleifer & Lawrence H. Summers & Robert J. Waldmann, . "Noise Trader Risk in Financial Markets," J. Bradford De Long's Working Papers _124, University of California at Berkeley, Economics Department.
  5. Fama, Eugene F., 1984. "Forward and spot exchange rates," Journal of Monetary Economics, Elsevier, vol. 14(3), pages 319-338, November.
  6. 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.
  7. Froot, Kenneth A & Frankel, Jeffrey A, 1989. "Forward Discount Bias: Is It an Exchange Risk Premium?," The Quarterly Journal of Economics, MIT Press, vol. 104(1), pages 139-61, February.
  8. 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.
  9. 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.
  10. Kahneman, Daniel & Tversky, Amos, 1979. "Prospect Theory: An Analysis of Decision under Risk," Econometrica, Econometric Society, vol. 47(2), pages 263-91, March.
  11. Bacchetta, Philippe & Mertens, Elmar & van Wincoop, Eric, 2009. "Predictability in financial markets: What do survey expectations tell us?," Journal of International Money and Finance, Elsevier, vol. 28(3), pages 406-426, April.
  12. MacDonald, Ronald & Torrance, T S, 1988. "On Risk, Rationality and Excessive Speculation in the Deutschmark-U.S. Dollar Exchange Market: Some Evidence Using Survey Data," Oxford Bulletin of Economics and Statistics, Department of Economics, University of Oxford, vol. 50(2), pages 107-23, May.
  13. Johansen, Soren, 1988. "Statistical analysis of cointegration vectors," Journal of Economic Dynamics and Control, Elsevier, vol. 12(2-3), pages 231-254.
  14. 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.
  15. Johansen, Soren, 1991. "Estimation and Hypothesis Testing of Cointegration Vectors in Gaussian Vector Autoregressive Models," Econometrica, Econometric Society, vol. 59(6), pages 1551-80, November.
  16. Engle, Robert F & Granger, Clive W J, 1987. "Co-integration and Error Correction: Representation, Estimation, and Testing," Econometrica, Econometric Society, vol. 55(2), pages 251-76, March.
  17. 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 759-70, November.
  18. Juselius, Katarina, 2006. "The Cointegrated VAR Model: Methodology and Applications," OUP Catalogue, Oxford University Press, number 9780199285679.
  19. Richard H. Thaler & Eric J. Johnson, 1990. "Gambling with the House Money and Trying to Break Even: The Effects of Prior Outcomes on Risky Choice," Management Science, INFORMS, vol. 36(6), pages 643-660, June.
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