Exchange Rate Risk and Business Cycles

47 Pages Posted: 18 Jun 2020

Date Written: June 10, 2020

Abstract

We show that currencies with a steeper yield curve tend to depreciate at business cycle horizons, in violation of uncovered interest parity. The yield curve adds no explanatory power over and above spot yield differentials in explaining exchange rates at longer horizons. Analysing bond holding period returns, we identify a tent-shaped relationship between the exchange rate risk premium and the relative slope across horizons. We derive this relationship analytically within an asset pricing framework and show it is driven by differences in transitory innovations to investors’ stochastic discount factor, captured by the relative yield curve slope and consistent with business cycle risk. Our mechanism is robust to the inclusion of liquidity yields, which instead contribute to explaining cross-sectional differences across currencies and reflect permanent innovations to investors’ stochastic discount factor.

Keywords: Business cycle risk, exchange rates, risk premia, stochastic discount factor, uncovered interest parity, yield curves

JEL Classification: E43, F31, G12

Suggested Citation

Lloyd, Simon and Marin, Emile Alexandre, Exchange Rate Risk and Business Cycles (June 10, 2020). Bank of England Working Paper No. 872, Available at SSRN: https://ssrn.com/abstract=3627728 or http://dx.doi.org/10.2139/ssrn.3627728

Simon Lloyd (Contact Author)

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

HOME PAGE: http://https://sites.google.com/view/splloyd

Emile Alexandre Marin

University of Cambridge ( email )

Trinity Ln
Cambridge, CB2 1TN
United Kingdom

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