International Risk Cycles
Federal Reserve Bank of Chicago
Board of Governors of the Federal Reserve System
Massachusetts Institute of Technology (MIT) - Sloan School of Management; National Bureau of Economic Research (NBER)
July 31, 2011
Recent work in international finance suggests that the forward premium puzzle can be accounted for if (1) aggregate uncertainty is time-varying, and (2) countries have heterogeneous exposures to a world aggregate shock. We embed these features in a standard two-country real business cycle framework, and calibrate the model to match the differences between low and high interest rates countries. Unlike traditional real business cycle models, our model generates volatile exchange rates, a large currency forward premium, "excess comovement'' of asset prices relative to quantities, and an imperfect correlation between relative consumption growth and exchange rates. Our model implies, however, that high interest rate countries have smoother quantities, equity returns and interest rates than low interest rate countries, contrary to the data.
Number of Pages in PDF File: 49
Date posted: September 3, 2010 ; Last revised: November 7, 2014