Bond risk premia, macroeconomic fundamentals and the exchange rate

Marcello Pericoli and Marco Taboga ()
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Marco Taboga: Bank of Italy

No 699, Temi di discussione (Economic working papers) from Bank of Italy, Economic Research and International Relations Area

Abstract: We introduce a two-country no-arbitrage term-structure model to analyse the joint dynamics of bond yields, macroeconomic variables, and the exchange rate. The model allows to understand how exogenous shocks to the exchange rate affect the yield curves, how bond yields co-move in different countries, and how the exchange rate is influenced by the interactions between macroeconomic variables and time-varying bond risk premia. Estimating the model with US and German data, we obtain an excellent fit of the yield curves and we are able to account for up to 75 per cent of the variability of the exchange rate. We find that time-varying risk premia play a non-negligible role in exchange rate fluctuations due to the fact that a currency tends to appreciate when risk premia on long-term bonds denominated in that currency rise. A number of other novel empirical findings emerge.

Keywords: exchange rate; term structure; UIP (search for similar items in EconPapers)
JEL-codes: C5 E4 G1 (search for similar items in EconPapers)
Date: 2009-03
New Economics Papers: this item is included in nep-cba, nep-fmk, nep-ifn, nep-mac and nep-mon
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Related works:
Journal Article: Bond risk premia, macroeconomic fundamentals and the exchange rate (2012)
Working Paper: Bond risk premia, macroeconomic fundamentals and the exchange rate (2008)
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Persistent link: https://EconPapers.repec.org/RePEc:bdi:wptemi:td_699_09

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