Foreign Exchange Rate Risk in a Small Open Economy

31 Pages Posted: 23 Mar 2009

See all articles by Bianca De Paoli

Bianca De Paoli

London School of Economics & Political Science (LSE) - Centre for Economic Performance (CEP)

Jens Sondergaard

Bank of England - Monetary Analysis

Date Written: March 20, 2009

Abstract

Resolving the forward premium puzzle requires a volatile foreign exchange rate risk premium that covaries negatively with the expected depreciation rate. Earlier work has shown how models featuring consumption habits can generate such premia when either trade costs or 'deep habits' are assumed. We show that as long as consumption habits are slow-moving and shocks are highly persistent, a standard small open endowment economy - without any additional features - can address the puzzle. Moreover endogenising the labour supply decision in the small open economy can improve the model's ability to match risk premia observations so long as it makes business cycles less synchronised.

Suggested Citation

De Paoli, Bianca and Sondergaard, Jens, Foreign Exchange Rate Risk in a Small Open Economy (March 20, 2009). Bank of England Working Paper No. 365, Available at SSRN: https://ssrn.com/abstract=1367059 or http://dx.doi.org/10.2139/ssrn.1367059

Bianca De Paoli

London School of Economics & Political Science (LSE) - Centre for Economic Performance (CEP) ( email )

Houghton Street
London WC2A 2AE
United Kingdom

Jens Sondergaard (Contact Author)

Bank of England - Monetary Analysis ( email )

Threadneedle Street
London EC2R 8AH
United Kingdom

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
110
Abstract Views
816
rank
301,725
PlumX Metrics