Incomplete Consumption Risk Sharing and Currency Risk Premiums

Abstract

This article studies the impact of imperfect consumption risk sharing across countries on the formation of time-varying risk premiums in the foreign exchange market and on their cross-sectional differences. These issues are addressed within the framework of the Constantinides and Duffie (1996) model applied to a multi-country world. The paper shows that the cross-country variance of consumption growth rates is counter-cyclical and that this feature of consumption data is mildly helpful for currency pricing. While the new model does not fully account for the forward premium anomaly, it is able to generate currency risk premiums at relatively low values of risk aversion and provide certain explanatory power for cross-sectional differences in currency returns.

Keywords: Forward Premium Puzzle, Conditional Asset Pricing, Implied Pricing Kernel, Consumption Dispersion Risk, Speculative Currency Returns

JEL Classification: C5, G12, G15