Currency Premia in Open Economies

Abstract:     
We develop a two-country international asset pricing model in which investors are heterogeneous. Exchange rate dynamics give rise to a currency risk premium, uncovered interest parity is violated. Countries whose output growth is expected to be sufficient to satisfy growth in demand have high interest rates. If demand for this country’s good is particularly risky — due to being dependent on exports to large countries whose residents have significant exposure to world stock markets — holding the currency requires a risk premium, making the carry trade profitable. Although returns are instantaneously Gaussian, endogenous dynamics can generate the impression of skewness in the time series. The endogenous cross-country demand for goods causes exchange rate volatility to rise as the exchange rate falls, giving the impression of a negatively skewed distribution.

Number of Pages in PDF File: 43

Keywords: Bond Markets, Interest Rates, Leverage Constraint, Carry Trade, Exchange Rates, International Finance

JEL Classification: G11, G12, G15, G18

working papers series