English, Article, Journal or magazine article edition: A Habit-Based Explanation of the Exchange Rate Risk Premium Adrien Verdelhan

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Physical Description
  • preprint
Language
  • English

Edition details

Title
  • A Habit-Based Explanation of the Exchange Rate Risk Premium
Author
  • Adrien Verdelhan
Physical Description
  • preprint
Notes
  • RePEc:bos:macppr:wp2006-047
  • RePEc:sce:scecfa:217
  • This paper presents a fully rational general equilibrium model that produces a time-varying exchange rate risk premium and solves the uncovered interest rate parity (U.I.P) puzzle. In this two-country model, agents are characterized by slow-moving external habit preferences similar to Campbell &​ Cochrane (1999). Endowment shocks are i.i.d and real risk-free rates are time-varying. Agents can trade across countries, but when a unit is shipped, only a fraction of the good arrives to the foreign shore. The model gives a rationale for the U.I.P puzzle: the domestic investor receives a positive exchange rate risk premium when she is effectively more risk-averse than her foreign counterpart. Times of high risk-aversion correspond to low interest rates. Thus, the domestic investor receives a positive risk premium when interest rates are lower at home than abroad. The model is both simulated and estimated. The simulation recovers the usual negative coefficient between exchange rate variations and interest rate differentials. When the iceberg-like trade cost is taken into account, the exchange rate variance produced is in line with its empirical counterpart. A nonlinear estimation of the model using consumption data leads to reasonable parameters when pricing the foreign excess returns of an American investor
  • RePEc:red:sed006:872
  • This paper presents a model that reproduces the uncovered interest rate parity puzzle, based on a time-varying business-cycle related risk premium. Agents have preferences with external habits. During bad times in the home market, when the domestic habit is close to domestic consumption level, the exchange rate becomes more sensitive to domestic than to foreign aggregate consumption growth shocks. As a result, the foreign currency depreciates in case of a negative consumption growth shock at home. Hence, investing in foreign currency is risky in bad times, when domestic interest rates are low relative to foreign interest rates.
  • RePEc:bos:wpaper:wp2006-047
  • This paper presents a fully rational general equilibrium model that produces a time- varying exchange rate risk premium and solves the uncovered interest rate parity (U.I.P) puzzle. In this two-country model, agents are characterized by slow-moving external habit preferences derived from Campbell &​ Cochrane (1999). Endowment shocks are i.i.d and real risk-free rates are time-varying. Agents can trade across countries, but when a unit is shipped, only a fraction of the good arrives to the foreign shore. The model gives a rationale for the U.I.P puzzle: the domestic investor receives a positive exchange rate risk premium when she is more risk-averse than her foreign counterpart. Times of high risk- aversion correspond to low interest rates. Thus, the domestic investor receives a positive risk premium when interest rates are lower at home than abroad. The model is both simulated and estimated. The simulation recovers the usual negative coefficient between exchange rate variations and interest rate differentials. When the iceberg-like trade cost is taken into account, the exchange rate variance produced is in line with its empirical counterpart. A nonlinear estimation of the model using consumption data leads to reasonable parameters when pricing the foreign excess returns of an American investor.
  • Exchange rate, Time-varying risk premium, Habits
  • RePEc:bos:wpaper:wp2005-032
Language
  • English
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