Hostname: page-component-586b7cd67f-rdxmf Total loading time: 0 Render date: 2024-11-23T01:37:49.988Z Has data issue: false hasContentIssue false
  • English
  • Français

MACROECONOMIC SHOCKS AND THE FOREIGN EXCHANGE RISK PREMIA

Published online by Cambridge University Press:  23 August 2006

SHIGERU IWATA  and
SHU WU
SHIGERU IWATA
Affiliation:
University of Kansas
SHU WU
Affiliation:
University of Kansas
Get access Rights & Permissions [Opens in a new window]

Abstract

In this paper we empirically examine the sources of the volatility of the foreign exchange risk premia. Using a nonlinear structural Vector Autoregression (VAR) model based on no-arbitrage condition to identify various macroeconomic shocks and the foreign exchange risk premia, we find that more than 80% of the volatilities of the currency risk premia can be accounted for by the standard macroeconomic shocks that drive output and inflation. By explicitly modelling the currency risk premia in the VAR system, we also offer a potential reconciliation for the seemingly contradicting observations from the previous VAR analysis of the exchange rate “overshooting” behavior under exogenous monetary innovations.

Keywords

Macroeconomic ShocksForeign Exchange Risk PremiaNonlinear VARExchange Rate Overshooting
Type
ARTICLES
Information
Macroeconomic Dynamics , Volume 10 , Issue 4 , September 2006 , pp. 439 - 466
Copyright
© 2006 Cambridge University Press

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

References

Ahn D.H., R.F. Dittmar and A.R. Gallant 2002 Quadratic Gaussian models: Theory and evidence. Review of Financial Studies 15, 243– 288.Google Scholar
Alvarez F., A. Atkeson and P. Kehoe 2002 Money, interest rates and exchange rates with endogenously segmented markets. Journal of Political Economy 110, 73– 112.Google Scholar
Backus D., A. Gregory and C. Telmer 1993 Accounting for forward rates in markets for foreign currency. Journal of Finance 48, 1887– 1908.Google Scholar
Backus D., S. Foresi and C. Telmer 2001 Affine models of currency pricing: Accounting for the forward premium anomaly. Journal of Finance 56, 279– 304.Google Scholar
Baillie, R. and T. Bollerslev 2000 The forward premium anomaly is not as bad as you think. Journal of International Money and Finance 19, 471– 488.Google Scholar
Bekaert G. 1996 The time-variation of risk and return in foreign exchange markets: A general equilibrium perspective. Review of Financial Studies 9, 427– 470.Google Scholar
Bekaert G. and R. Hodrick 1992 Characterizing predictable components in excess returns on equity and foreign exchange market. Journal of Finance 47, 467– 509.Google Scholar
Bekaert G., R. Hodrick and D. Marshall 1997 The implications of first-order risk aversion for asset market risk premia. Journal of Monetary Economics 40, 3– 39.Google Scholar
Brandt M., J. Cochrane and P. Santa-Clara 2006 International risk sharing is better than you think. Journal of Monetary Economics 53, 671– 698.Google Scholar
Chari V., P. Kehoe and E. McGrattan 2003 Can sticky price models generate volatile and persistent real exchange rates? Review of Economic Studies 69, 533– 564.Google Scholar
Christiano L.J., M. Eichenbaum and C.L. Evans 1999 Monetary policy shocks: What have we learned and to what end? In J. Taylor and M. Woodford (eds.), Handbook of Macroeconomics, Vol. 1A, pp. 65– 148. Amsterdam: North-Holland.
Clarida R. and J. Gali 1994 Sources of real exchange rate fluctuations: How important are nominal shocks? Carnegie-Rochester Conference Series on Public Policy 41, 1– 56.Google Scholar
Cochrane J.H. 2001 Asset Pricing. Princeton: Princeton University Press.
Constantinides G. 1992 A theory of the nominal term structure of interest rate. Review of Financial Studies 5, 531– 552.Google Scholar
Cushman D. and T. Zha 1997 Identifying monetary policy in a small open economy under flexible exchange rates. Journal of Monetary Economics 39, 433– 448.Google Scholar
Dai Q. and K. Singleton 2002 Expectation puzzles, time-varying risk premia, and affine models of the term structure. Journal of Financial Economics 63, 415– 441.Google Scholar
Dornbush R. 1976 Expectations and exchange dynamics. Journal of Political Economy 84, 1161– 1176.Google Scholar
Eichenbaum M. and C. Evans 1995 Some empirical evidence on the effects of shocks to monetary policy on exchange rates. Quarterly Journal of Economics 110, 975– 1009.Google Scholar
Engel C. 1996 The forward discount anomaly and the risk premium: A survey of recent evidence. Journal of Empirical Finance 3, 123– 192.Google Scholar
Evans C. 1994 Interest rate shocks and the dollar. Economic Perspective 8, 11– 24.Google Scholar
Fama E. 1984 Forward and spot exchange rates. Journal of Monetary Economics 14, 319– 338.Google Scholar
Faust J. and J. Rogers 2003 Monetary policy's role in exchange rate behavior. Journal of Monetary Economics 50, 1403– 1424.Google Scholar
Gallant A.R., P.E. Rossi and G. Tauchen 1993 Nonlinear dynamic structures. Econometrica 61, 871– 907.Google Scholar
Grilli V. and N. Roubini 1996 Liquidity models in open economies: Theory and empirical evidence. European Economic Review 40, 847– 859.Google Scholar
Gourinchas P. and A. Tornell 1996 Exchange Rate Dynamics and Learning. NBER Working Paper 5530.Google Scholar
Harrison J. and D. Kreps 1979 Martingales and arbitrage in multiperiod securities markets. Journal of Economic Theory 23, 381– 408.Google Scholar
Hodrick R. 1987 The Empirical Evidence on the Efficiency of Forward and Futures Foreign Exchange Markets. Chur, Switzerland: Harwood Academic Publishers.
Hollifield B. and A. Yaron 2000 The Foreign Exchange Risk Premium: Real and Nominal Factors. Manuscript, Carnegie Mellon University.
Koop G., M.H. Pesaran and S.M. Potter 1996 Impulse response analysis in nonlinear multivariate models. Journal of Econometrics 74, 119– 147.Google Scholar
Lewis K. 1995 Puzzles in international financial markets. In G. Grossman and K. Rogoff (eds.), Handbook of International Economics, Vol. 3, 1913– 1974. Amsterdam: North-Holland.
Lucas R. 1982 Interest rates and currency prices in a two-country world. Journal of Monetary Economics 10, 335– 359.Google Scholar
Potter S.M. 2000 Nonlinear impulse response functions. Journal of Economic Dynamics & Control 24, 1425– 1446.Google Scholar