International Finance and Exchange Rates
Friday, Jan. 6, 2017 10:15 AM – 12:15 PM
Sheraton Grand Chicago, Chicago Ballroom VIII
- Chair: Hanno Lustig, Stanford University
Real Exchange Rates and Currency Risk Premia
AbstractWe exploit the link between deviations from uncovered interest rate parity (UIP), long-run relative purchasing power parity (PPP), and deviations from real rate equality, to develop more powerful tests of the predictive power of real exchange rates for excess currency returns. Assuming long-run relative
PPP, we obtain much stronger evidence of predictability than if we test UIP in isolation. The real exchange rate is also the main driver of long-horizon UIP deviations and a dominant fraction of the real exchange rate variance is due to UIP deviations. Modified versions of the "habit" and "long-run risks" models qualitatively replicate these findings.
Uncertainty, the Exchange Rate and International Capital Flows
AbstractThis paper analyzes the effects of output volatility shocks and of risk appetite shocks on
the dynamics of the real exchange rate, consumption and net foreign assets, in a two country
world with recursive preferences and complete financial markets. When the risk aversion coefficient exceeds the inverse of the intertemporal substitution elasticity, then an exogenous rise in a country’s output volatility triggers a wealth transfer to that country, in equilibrium; this raises its consumption, lowers its trade balance and appreciates its real exchange rate. The effects of risk appetite shocks resemble those of volatility shocks. In a recursive preferences-complete markets framework, volatility and risk appetite shocks account for a noticeable share of the fluctuations of the real exchange rate, net exports and net foreign assets. These shocks help to explain the high empirical volatility of the real exchange rate and the disconnect between relative consumption growth and the real exchange rate.
Entangled Risks in Incomplete FX Markets
AbstractWe study the implications of risk entanglements on international financial (FX) markets. Risk entanglement is a refinement of incomplete markets that some risks in asset markets cannot be singly traded. We show that in FX markets with entangled risks (i) there exist multiple pricing-consistent exchange rates, (ii) every exchange rate is affected by idiosyncratic risks, and (iii) exchange rates can be smooth while stochastic discount factors (SDFs) are volatile and almost uncorrelated. These results are in stark contrast to the case of complete markets or incomplete markets without risk entanglements.
University of Chicago
University of British Columbia
University of North Carolina-Chapel Hill
- G1 - Asset Markets and Pricing