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Time-Varying Risk, Interest Rates, and Exchange Rates in General EquilibriumFernando AlvarezUniversity of Chicago - Department of Economics; National Bureau of Economic Research (NBER) Andrew AtkesonUniversity of California, Los Angeles (UCLA) - Department of Economics; National Bureau of Economic Research (NBER) Patrick J. KehoeFederal Reserve Bank of Minneapolis - Research Department; University of Minnesota - Twin Cities - Department of Economics; National Bureau of Economic Research (NBER) March 1, 2006 Abstract: Under mild assumptions, the data indicate that fluctuations in nominal interest rate differentials across currencies are primarily fluctuations in time-varying risk. This finding is an immediate implication of the fact that exchange rates are roughly random walks. If most fluctuations in interest differentials are thought to be driven by monetary policy, then the data call for a theory which explains how changes in monetary policy change risk. Here we propose such a theory based on a general equilibrium monetary model with an endogenous source of risk variation-a variable degree of asset market segmentation.
Keywords: Forward Premium Anomaly, Fama Puzzle, Time-Varying Conditional Variances, Asset Pricing-Puzzle, Segmented Markets, Pricing Kernel JEL Classification: E43, F3, F31, F41, G12, G15 working papers seriesDate posted: July 25, 2008Suggested CitationContact Information
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