Expected Currency Excess Returns and International Business Cycles

Sanglim Lee

No 2012-16, Working papers from University of Connecticut, Department of Economics

Abstract: It is well known that the uncovered interest parity condition does not hold empirically, implying that investments in high-interest rate currencies in foreign currency markets result in a positive expected excess return. Verdelhan (2010) successfully explains this phenomenon by referring to exogenous consumption processes and external habit formation. In this paper, I extend his model by using an international real business cycle model (Backus, Kehoe, and Kydland 1994) with internal habit formation. When the production-based stochastic discount factor is used, this benchmark model, driven by total factor productivity, accounts for this empirical evidence as well. JEL Classification: E32, E44, F31, F44 Key words: Currency Excess Return, Real Business Cycle, Forward Premium Puzzle

Pages: 45 pages
Date: 2012-09
New Economics Papers: this item is included in nep-bec, nep-dge, nep-fmk, nep-mac and nep-opm
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