Investing in Foreign Currency is like Betting on your Intertemporal Marginal Rate of Substitution

Hanno Lustig and Adrien Verdelhan ()

No WP2005-040, Boston University - Department of Economics - Working Papers Series from Boston University - Department of Economics

Abstract: Investors earn positive excess returns on high interest rate foreign discount bonds, because these currencies appreciate on average. Lustig and Verdelhan (2005) show that investing in high interest rate foreign discount bonds exposes them to more aggregate consumption risk, while low interest rate foreign bonds provide a hedge. This paper provides a simple model that replicates these facts. Investing in foreign currency is like betting on the di®erence between your own intertemporal; marginal rate of substitution (IMRS) and your neighbor's IMRS. These bets are very risky if your neighbor's IMRS is not correlated with yours, but they provide a hedge when his IMRS is highly correlated and more volatile. If the foreign neighbors that face low interest rates also have more volatile and correlated IMRS, that accounts for the spread in excess returns in the data.

Keywords: Exchange Rates; Currency Risk. (search for similar items in EconPapers)
Pages: 11 pages
Date: 2005-10
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Journal Article: Investing in Foreign Currency is like Betting on your Intertemporal Marginal Rate of Substitution (2006)
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