U.S. Dollar Dynamics: How Important are Policy Divergence and FX Risk Premiums?

48 Pages Posted: 9 Dec 2016

See all articles by Ravi Balakrishnan

Ravi Balakrishnan

International Monetary Fund (IMF) - Fiscal Affairs Department

Stefan Laseen

International Monetary Fund (IMF)

Andreas Pescatori

International Monetary Fund (IMF)

Date Written: July 2016

Abstract

We investigate the drivers of dynamics of major U.S. FX bilaterals. We first construct a novel measure of FX risk premiums using Consensus exchange rate forecasts. We then use VAR analysis to show that (i) risk premium shocks play a key role in driving dynamics of the major U.S. FX bilaterals; (ii) longer-term interest differentials also matter, especially for the Canadian $ and the Euro; (iii) oil price shocks play a particularly important role for the Canadian $ (an oil exporter); and (iv) risk appetite shocks (e.g., VIX shocks) generally lead to U.S. dollar appreciation. The importance of risk premium and longer-term interest differential shocks fit well with a simple theoretical model and are supported by recent event studies.

Keywords: US dollar, United States, Foreign exchange, Risk premium, External shocks, Monetary policy, Structural vector autoregression, General equilibrium models, Foreign exchange, monetary policy shocks, FX risk premium, SVAR

JEL Classification: E43, F31, G15

Suggested Citation

Balakrishnan, Ravi and Laseen, Stefan and Pescatori, Andreas, U.S. Dollar Dynamics: How Important are Policy Divergence and FX Risk Premiums? (July 2016). IMF Working Paper No. 16/125. Available at SSRN: https://ssrn.com/abstract=2882560

Ravi Balakrishnan (Contact Author)

International Monetary Fund (IMF) - Fiscal Affairs Department ( email )

700 19th Street, NW
Washington, DC 20431
United States
001 202 623 5674 (Phone)
001 202 623 6249 (Fax)

Stefan Laseen

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

Andreas Pescatori

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

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