Exchange Rates, Expected Returns and Risk: UIP Unbound

47 Pages Posted: 3 Dec 2014 Last revised: 4 Dec 2014

Date Written: December 1, 2014

Abstract

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

Munro, Anella Elizabeth, Exchange Rates, Expected Returns and Risk: UIP Unbound (December 1, 2014). Available at SSRN: https://ssrn.com/abstract=2532731 or http://dx.doi.org/10.2139/ssrn.2532731

Anella Elizabeth Munro (Contact Author)

Reserve Bank of New Zealand ( email )

2 The Terrace
P.O. Box 2498
Wellington, 6011
New Zealand

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