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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 finds strong evidence of a positive relationship between currency risk premia and real exchange rate swings, significant at the 1% if not 0.1% level, for three USD exchange rate samples. The risk premia are measured using survey data on traders' exchange rate forecasts. This circumvents the need for an auxiliary hypothesis of rationality and enables more direct focus on risk behavior. The analysis is conducted using the I(2) cointegrated VAR which allows for time-varying trends in the variables. Evidence of persistent changes is found for interest rates, prices, and nominal and real exchange rates. Interest rate shocks appear to drive the system, while expectations are correcting only in the longer-run.

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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: 32 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. 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.
  2. 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.
  3. 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.
  4. Taylor, Alan M. & Taylor, Mark P, 2004. "The Purchasing Power Parity Debate," CEPR Discussion Papers 4495, C.E.P.R. Discussion Papers.
  5. Froot, Kenneth A. & Frankel, Jeffrey A., 1988. "Forward Discount Bias: Is It an Exchange Risk Premium?," Department of Economics, Working Paper Series qt5w65g4zg, Department of Economics, Institute for Business and Economic Research, UC Berkeley.
  6. 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 703-38, August.
  7. 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.
  8. 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.
  9. Amos Tversky & Daniel Kahneman, 1979. "Prospect Theory: An Analysis of Decision under Risk," Levine's Working Paper Archive 7656, David K. Levine.
  10. 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.
  11. Bacchetta, Philippe & Mertens, Elmar & van Wincoop, Eric, 2006. "Predictability in Financial Markets: What Do Survey Expectations Tell Us?," CEPR Discussion Papers 5770, C.E.P.R. Discussion Papers.
  12. Nelson Mark & Yangru Wu, 1998. "Rethinking Deviations from Uncovered Interest Parity: The Role of Covariance Risk and Noise," Working Papers 98-05, Ohio State University, Department of Economics.
  13. 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.
  14. Juselius, Katarina, 2006. "The Cointegrated VAR Model: Methodology and Applications," OUP Catalogue, Oxford University Press, number 9780199285679, May.
  15. 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.
  16. Johansen, Soren, 1988. "Statistical analysis of cointegration vectors," Journal of Economic Dynamics and Control, Elsevier, vol. 12(2-3), pages 231-254.
  17. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-76, December.
  18. Fama, Eugene F., 1984. "Forward and spot exchange rates," Journal of Monetary Economics, Elsevier, vol. 14(3), pages 319-338, November.
  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.
  20. Shlomo Benartzi & Richard H. Thaler, 1995. "Myopic Loss Aversion and the Equity Premium Puzzle," The Quarterly Journal of Economics, Oxford University Press, vol. 110(1), pages 73-92.
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