Covered Purchasing Power Parity, Ex-Ante PPP and Risk Aversion

Michael Moore

No 635, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: The standard expectations augmented theory of ex-ante purchasing power parity (PPP), which was first developed by Roll, assumes that agents are risk neutral. A Covered Purchasing Power Condition is developed which holds for the general case of risk aversion. A risk-augmented form of ex-ante PPP is then derived using a Lucas-style asset pricing framework. From this I conclude that real exchange rates may not possess the martingale property though the analysis clarifies the circumstances under which this property does hold.A consumption-based orthogonality condition is tested for, using 1970s and 1980s data for the seven main industrial countries. An interesting by-product of the study is that it provides us with a useful example of unit root testing on seasonal data. Overall the results give rise to cautious optimism.

Keywords: Arbitrage; Purchasing Power Parity; Risk Aversion (search for similar items in EconPapers)
JEL-codes: F31 G12 G15 (search for similar items in EconPapers)
Date: 1992-04
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Citations: View citations in EconPapers (3)

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Journal Article: Covered Purchasing Power Parity, Ex‐ante PPP and Risk Aversion (1997)
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