Foreign Exchange Risk Premia and Welfare in a Stochastic Small Open Economy Model

19 Pages Posted: 26 Mar 2001

See all articles by Lynne Evans

Lynne Evans

Durham University - Department of Economics and Finance

Turalay Kenc

University of London - Imperial College

Date Written: May 2001

Abstract

This paper constructs a stochastic general equilibrium model of a small open economy consisting of risk-averse optimising agents with unconventional preferences. We use this model (i) to analyze the determinants of the foreign exchange rate risk premium; (ii) to explore the importance of unconventional preferences for the foreign exchange rate risk premium; and (iii) to conduct a numerical analaysis of the forex risk premium. Our model is distinguished from many of those in the literature by a number of features. Firstly, our dynamic general equilibrium model incorporates portfolio choice thereby giving rise to an integrated analysis of exchange rate determination with a risk-adjusted PPP and portfolio equilibrium. Secondly, the model includes a recursive utility function that disentangles risk aversion from intertemporal substitution thereby enabling an analysis of the distinct roles played by agents' attitudes towards risk and intertemporal substitution. Thirdly, in preference to using a two-country model, we specifically model a small open economy which takes the world interest rate as given. Fourthly, we have an exact stochastic model rather than the stochastic approximations (through Markov chains) more commonly adopted in the literature; and, fifthly, the model is constructed in continuous, not discrete, time. We find that the equilibrium forex risk premium is a function of exogenous shocks in the model and is sensitive to assumed attitudes towards risk and intertemporal substitution. Furthermore, taking plausible values for the preference parameters, together with other data-driven parameter values, the model generates a value for the forex risk premium which is close to that found in the data.

Keywords: Exchange rate, Foreign exchange rate risk premium, Recursive utility, Stochastic general equilibrium models

Suggested Citation

Evans, Lynne and Kenc, Turalay, Foreign Exchange Risk Premia and Welfare in a Stochastic Small Open Economy Model (May 2001). Available at SSRN: https://ssrn.com/abstract=264767 or http://dx.doi.org/10.2139/ssrn.264767

Lynne Evans (Contact Author)

Durham University - Department of Economics and Finance ( email )

Durham, DH1 3HY
United Kingdom
+44-191-3747287 (Phone)
+44-191-3747289 (Fax)

Turalay Kenc

University of London - Imperial College ( email )

Exhibition Road
London SW7 2AZ
United Kingdom
+44 20 7594 9212 (Phone)
+44 20 7823 7685 (Fax)

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