Intertemporal Substitution, Precautionary Saving, and the Currency Risk Premia

33 Pages Posted: 10 May 2018 Last revised: 19 Oct 2020

See all articles by Rui Chen

Rui Chen

Central University of Finance and Economics (CUFE)

Ke Du

Institute of Financial Studies (IFS), Southwestern University of Finance and Economics (SWUFE)

Jun Liu

University of California, San Diego (UCSD) - Rady School of Management

Date Written: October 18, 2020

Abstract

There are two seemingly contradictory empirical regularities in international finance: the high interest rate currency tends to have higher currency risk premia in short horizons but lower currency risk premia in long horizons. Engel (2016) shows that existing models cannot accommodate these two puzzles simultaneously and terms them a paradox. In this paper, we provide a rational resolution to Engel's paradox. Our deviation from existing models is the following two assumptions on consumption processes: (i) the expected future consumption variance have more than one decay modes and (ii) the mean consumption growth depends on the slowest decay mode. Market friction, recursive utility and bounded rationality are not assumed. Calibration exercises confirm key implications of our model.

Keywords: Interest rates, exchange rates, currency risk premia, intertemporal substitution, precautionary saving

JEL Classification: E43, F31, G15

Suggested Citation

Chen, Rui and Du, Ke and Liu, Jun, Intertemporal Substitution, Precautionary Saving, and the Currency Risk Premia (October 18, 2020). Available at SSRN: https://ssrn.com/abstract=3169382 or http://dx.doi.org/10.2139/ssrn.3169382

Rui Chen

Central University of Finance and Economics (CUFE) ( email )

39 South College Road
Haidian District
Beijing, Beijing 100081
China

Ke Du (Contact Author)

Institute of Financial Studies (IFS), Southwestern University of Finance and Economics (SWUFE) ( email )

55 Guanghuacun St,
Chengdu, Sichuan 610074
China

Jun Liu

University of California, San Diego (UCSD) - Rady School of Management ( email )

9500 Gilman Drive
Rady School of Management
La Jolla, CA 92093
United States
858.534.2022 (Phone)
5858.534.0745 (Fax)

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