Exchange Rate Risk and Business Cycles

Simon Lloyd and Emile Marin

Cambridge Working Papers in Economics from Faculty of Economics, University of Cambridge

Abstract: We show that currencies with a steeper yield curve depreciate at business-cycle horizons. We identify a tent-shaped relationship between exchange-rate risk premia (ERRP) and the relative yield curve slope across horizons that peaks at 3-5 years and is robust to a number of controls, including liquidity yields. Within a no-arbitrage framework, ERRP reflect investors' changing return valuations over the business cycle. We calibrate a two-country, two-factor model of interest rates, where exchange rates are driven by business-cycle - transitory and cyclical - risk. The model quantitatively reproduces the tent-shaped relationship, as well as variation in uncovered interest parity coefficients across horizons.

Keywords: Business-cycle risk; Exchange rates; Risk premia; Stochastic discount factor; Uncovered interest parity; Yield curves (search for similar items in EconPapers)
JEL-codes: E43 F31 G12 (search for similar items in EconPapers)
Date: 2019-12-03
New Economics Papers: this item is included in nep-mac and nep-opm
Note: eam65
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

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Working Paper: Exchange rate risk and business cycles (2020)
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Persistent link: https://EconPapers.repec.org/RePEc:cam:camdae:1996

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