Macroeconomic and policy uncertainty and Exchange rate risk Premium

Juan Jimenez-Martin and Rodrigo Peruga Urrea
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Rodrigo Peruga Urrea: niversidad Complutense de Madrid. Facultad de CC. Económicas y Empresariales. Dpto. de Fundamentos de Análisis Económico II., https://www.ucm.es/fundamentos-analisis-economico2

Documentos de Trabajo del ICAE from Universidad Complutense de Madrid, Facultad de Ciencias Económicas y Empresariales, Instituto Complutense de Análisis Económico

Abstract: The goal of this paper is to identify the main determinants of the risk premium in some European currency markets just before the EMU. To that extent, we start from Lucas (1982) exchange rate model and derive an analytical expression for the forward premium. This expression includes money and production variables and it is quite standard, except for the inclusion of macroeconomic policy risk. Under some standard assumptions, this formula simplifies substantially and becomes amenable to regression analysis. Then, using standard measures of money and production, as well as interest rate swap spreads as indicators of macroeconomic policy risk, the theoretical expression is estimated. We provide evidence suggesting that it is policy uncertainty, much more than fundamental macroeconomic uncertainty, which determined risk premium over the convergence process to the euro. Whether these results can be extended to similar experiences for other currency unions remains open for future research.

Keywords: Risk premium; Peso Problem; Macroeconomic policy risk; European monetary System. (search for similar items in EconPapers)
JEL-codes: F31 F41 G12 G15 (search for similar items in EconPapers)
Pages: 32 pages
Date: 2004
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