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Exchange rate risk and business cycles

Simon Lloyd and Emile Marin ()
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Emile Marin: University of Cambridge

No 872, Bank of England working papers from Bank of England

Abstract: We show that currencies with a steeper yield curve tend to depreciate at business cycle horizons, in violation of uncovered interest parity. The yield curve adds no explanatory power over and above spot yield differentials in explaining exchange rates at longer horizons. Analysing bond holding period returns, we identify a tent-shaped relationship between the exchange rate risk premium and the relative slope across horizons. We derive this relationship analytically within an asset pricing framework and show it is driven by differences in transitory innovations to investors’ stochastic discount factor, captured by the relative yield curve slope and consistent with business cycle risk. Our mechanism is robust to the inclusion of liquidity yields, which instead contribute to explaining cross-sectional differences across currencies and reflect permanent innovations to investors’ stochastic discount factor.

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)
Pages: 47 pages
Date: 2020-06-12
New Economics Papers: this item is included in nep-mac and nep-opm
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Working Paper: Exchange Rate Risk and Business Cycles (2019) Downloads
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