Exchange rates, expected returns and risk: UIP unbound

Anella Munro

CAMA Working Papers from Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University

Abstract: No-arbitrage implies a close link between exchange rates and interest returns, but evidence of that link has been elusive. This paper derives an exchange rate asset price model with consumption-risk adjustments. Interest rates and exchange rates reflect common risks which bias their reduced-form relationship. As markets become more complete, the model predicts increasing disconnect between exchange rates and observed interest rates, and between premia that price bonds and premia that price currency returns. When accounting for risk, the estimated interest rate - exchange rate relationship is considerably closer to theory for eight USD currency pairs. Exchange rates, risk and returns need to be jointly modeled.

Keywords: Exchange rate; asset price; risk adjustment; uncovered interest parity; bond premium; currency premium (search for similar items in EconPapers)
JEL-codes: F31 G12 (search for similar items in EconPapers)
Pages: 47 pages
Date: 2014-12
New Economics Papers: this item is included in nep-mon and nep-opm
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

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Related works:
Working Paper: Exchange rates, expected returns and risk (2014)
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Persistent link: https://EconPapers.repec.org/RePEc:een:camaaa:2014-73

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