Time-Varying International Diversification and the Forward Premium

29 Pages Posted: 21 Mar 2011 Last revised: 8 Jun 2013

See all articles by Benjamin Jonen

Benjamin Jonen

University of Zurich

Simon Scheuring

University of Zurich - Department of Banking and Finance

Date Written: June 8, 2013

Abstract

This paper reproduces the slope of the uncovered interest rate parity (UIP) regression for ten country pairs within one standard deviation under rational expectations. We propose an infinite horizon dynamic stochastic general equilibrium model with incomplete markets. Heterogenous investors experience varying risk aversion as a result of habit formation.

The underlying mechanism of the model relies on varying international diversification in the investors' portfolio choice decision. In response to their changing habit levels, investors' hedging desire varies over time. This leads to adjustments in interest rates. The habit-induced investment decisions are negatively correlated with movements in the exchange rate. This results in a negative correlation between interest rates and expected exchange rates, as implied by a negative UIP slope.

Depending on the magnitude of habits, the model is capable of reproducing positive as well as negative UIP slopes, as seen empirically in the data.

Keywords: Forward Premium, Habits, International Diversification

JEL Classification: F31, G12, G15

Suggested Citation

Jonen, Benjamin and Scheuring, Simon, Time-Varying International Diversification and the Forward Premium (June 8, 2013). Available at SSRN: https://ssrn.com/abstract=1787370 or http://dx.doi.org/10.2139/ssrn.1787370

Benjamin Jonen

University of Zurich ( email )

Rämistrasse 71
Zürich, CH-8006
Switzerland

Simon Scheuring (Contact Author)

University of Zurich - Department of Banking and Finance ( email )

Schönberggasse 1
Zürich, 8001
Switzerland

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