U.S. Dollar Dynamics: How Important Are Policy Divergence and FX Risk Premiums?

Ravi Balakrishnan, Stefan Laséen () and Andrea Pescatori

No 2016/125, IMF Working Papers from International Monetary Fund

Abstract: We investigate the drivers of dynamics of major U.S. FX bilaterals. We first construct a novel measure of FX risk premiums using Consensus exchange rate forecasts. We then use VAR analysis to show that (i) risk premium shocks play a key role in driving dynamics of the major U.S. FX bilaterals; (ii) longer-term interest differentials also matter, especially for the Canadian $ and the Euro; (iii) oil price shocks play a particularly important role for the Canadian $ (an oil exporter); and (iv) risk appetite shocks (e.g., VIX shocks) generally lead to U.S. dollar appreciation. The importance of risk premium and longer-term interest differential shocks fit well with a simple theoretical model and are supported by recent event studies.

Keywords: WP; risk premium; FX risk premium; U.S. dollar; Foreign exchange; monetary policy shocks; SVAR; monetary policy shock; C. risk premium estimate; exogenous risk premium process; constructed risk premium; assets vis; exchange rate movement; Return on investment; Exchange rates; Exchange rate risk; Exchange rate adjustments; Global (search for similar items in EconPapers)
Pages: 47
Date: 2016-07-05
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Citations: View citations in EconPapers (5)

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