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The Consumption - Real Exchange Rate Anomaly: an Asset Pricing Perspective

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  • Mathias Hoffmann
  • Thomas Nitschka

Abstract

Idiosyncratic consumption risk explains more than 60 percent of the cross-sectional variation in quarterly exchange rate changes and currency returns. Our results are obtained from data of 13 industrialized countries and are based on an international version of the consumption capital asset pricing model (CCAPM) in which we account for international consumption heterogeneity. We use this framework to dissect the consumption-exchange rate anomaly, the empirical fact that international variation in purchasing power alone does not appear to account for differences in consumption growth rates across countries. As an explanation for this phenomenon, we explore the presence of currency risk premia that also lead to departures from uncovered interest parity (UIP). We decompose the cross-sectional variation in consumption into one component that is due to cross-country differences in inflation rates and a second component that is due to international variation in nominal interest rates. We interpret these factors as indicators of goods and financial market segmentation respectively. We find that both help account to virtually equal parts for the cross-section of exchange rate changes. Interestingly, the price of aggregate consumption risk has declined over the 1990s, in line with a growing literature that documents a growing internationalisation of country portfolios over this period.

Suggested Citation

  • Mathias Hoffmann & Thomas Nitschka, 2007. "The Consumption - Real Exchange Rate Anomaly: an Asset Pricing Perspective," IEW - Working Papers 331, Institute for Empirical Research in Economics - University of Zurich.
  • Handle: RePEc:zur:iewwpx:331
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    File URL: http://www.econ.uzh.ch/static/wp_iew/iewwp331.pdf
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    References listed on IDEAS

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    1. Hanno Lustig & Adrien Verdelhan, 2007. "The Cross Section of Foreign Currency Risk Premia and Consumption Growth Risk," American Economic Review, American Economic Association, vol. 97(1), pages 89-117, March.
    2. Kollmann, Robert, 1995. "Consumption, real exchange rates and the structure of international asset markets," Journal of International Money and Finance, Elsevier, vol. 14(2), pages 191-211, April.
    3. Shanken, Jay, 1992. "On the Estimation of Beta-Pricing Models," Review of Financial Studies, Society for Financial Studies, vol. 5(1), pages 1-33.
    4. Sergei Sarkissian, 2003. "Incomplete Consumption Risk Sharing and Currency Risk Premiums," Review of Financial Studies, Society for Financial Studies, vol. 16(3), pages 983-1005, July.
    5. Ravn, Morten O, 2001. "Consumption Dynamics and Real Exchange Rate," CEPR Discussion Papers 2940, C.E.P.R. Discussion Papers.
    Full references (including those not matched with items on IDEAS)

    More about this item

    Keywords

    Uncovered interest rate parity; consumption CAPM; international financial integration; consumption risk sharing;

    JEL classification:

    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • F30 - International Economics - - International Finance - - - General
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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