Exchange Rates, Expected Returns and Risk: UIP Unbound
47 Pages Posted: 3 Dec 2014 Last revised: 4 Dec 2014
Date Written: December 1, 2014
No-arbitrage implies a close link between exchange rates and interest returns, but evidence of that link has been elusive. This paper derives an exchange rate asset price model with consumption-risk adjustments. Interest rates and exchange rates reflect common risks which bias their reduced-form relationship. As markets become more complete, the model predicts increasing disconnect between exchange rates and observed interest rates, and between premia that price bonds and premia that price currency returns. When accounting for risk, the estimated interest rate - exchange rate relationship is considerably closer to theory for eight USD currency pairs. Exchange rates, risk and returns need to be jointly modeled.
Keywords: Exchange rate, asset price, risk adjustment, uncovered interest parity, bond premium, currency premium
JEL Classification: F31, G12
Suggested Citation: Suggested Citation