A Habit-Based Explanation of the Exchange Rate Risk Premium

Adrien Verdelhan ()

No WP2005-032, Boston University - Department of Economics - Working Papers Series from Boston University - Department of Economics

Abstract: This paper presents a fully rational general equilibrium model that produces a time- varying exchange rate risk premium and solves the uncovered interest rate parity (U.I.P) puzzle. In this two-country model, agents are characterized by slow-moving external habit preferences derived from Campbell & Cochrane (1999). Endowment shocks are i.i.d and real risk-free rates are time-varying. Agents can trade across countries, but when a unit is shipped, only a fraction of the good arrives to the foreign shore. The model gives a rationale for the U.I.P puzzle: the domestic investor receives a positive exchange rate risk premium when she is more risk-averse than her foreign counterpart. Times of high risk- aversion correspond to low interest rates. Thus, the domestic investor receives a positive risk premium when interest rates are lower at home than abroad. The model is both simulated and estimated. The simulation recovers the usual negative coefficient between exchange rate variations and interest rate differentials. When the iceberg-like trade cost is taken into account, the exchange rate variance produced is in line with its empirical counterpart. A nonlinear estimation of the model using consumption data leads to reasonable parameters when pricing the foreign excess returns of an American investor.

Keywords: Exchange rate; Time-varying risk premium; Habits (search for similar items in EconPapers)
JEL-codes: F31 G12 G15 (search for similar items in EconPapers)
Pages: 47 pages
Date: 2005-08
New Economics Papers: this item is included in nep-fin and nep-mac
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (6)

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Related works:
Journal Article: A Habit‐Based Explanation of the Exchange Rate Risk Premium (2010)
Working Paper: A Habit-Based Explanation of the Exchange Rate Risk Premium (2006)
Working Paper: A Habit-Based Explanation of the Exchange Rate Risk Premium (2006)
Working Paper: A Habit-Based Explanation of the Exchange Rate Risk Premium (2006)
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