On the Driving Forces of Real Exchange Rates: Is the Japanese Yen Different?

70 Pages Posted: 16 Sep 2014 Last revised: 10 Nov 2019

See all articles by Paulo F. Maio

Paulo F. Maio

Hanken School of Economics - Department of Finance and Statistics

Ming Zeng

University of Gothenburg - Centre for Finance

Multiple version iconThere are 2 versions of this paper

Date Written: November 8, 2019

Abstract

We estimate variance decompositions of the real exchange rates for 19 individual currencies based on a present-value relation. We document substantial heterogeneity across forecasting horizons and currencies regarding the determinants of exchange rates. At short horizons, the dominant force is predictability of the future spot rates. At long horizons, return predictability drives most of the variation in exchange rates, with predictability of interest differentials playing a secondary role. However, for the Japanese Yen (JPY) the main determinant is long-run interest spread predictability, a pattern that occurs in the most recent period. We develop a liquidity-based exchange rate model to explain such evidence. Agents value the liquidity benefit of near-money assets and have non-separable utility over consumption and liquidity services. Cross-country differentials in liquidity demand determine exchange rates and affect both interest differentials and risk premiums in a way consistent with the data. The quantitative simulation correctly replicates our empirical findings.

Keywords: exchange rates, currency return and interest spread predictability, Japanese Yen, variance decompositions, present-value relation, liquidity premium, calibration and simulation

JEL Classification: F31, G12, G15, G17

Suggested Citation

Maio, Paulo F. and Zeng, Ming, On the Driving Forces of Real Exchange Rates: Is the Japanese Yen Different? (November 8, 2019). Available at SSRN: https://ssrn.com/abstract=2496439 or http://dx.doi.org/10.2139/ssrn.2496439

Paulo F. Maio (Contact Author)

Hanken School of Economics - Department of Finance and Statistics ( email )

FI-00101 Helsinki
Finland

HOME PAGE: http://sites.google.com/site/paulofmaio/home

Ming Zeng

University of Gothenburg - Centre for Finance ( email )

Vasagatan 1
Göteborg, 40530
Sweden

Register to save articles to
your library

Register

Paper statistics

Downloads
182
Abstract Views
1,009
rank
153,455
PlumX Metrics