Macro Variables Do Drive Exchange Rate Movements: Evidence from a No-Arbitrage Model

56 Pages Posted: 23 Jul 2006

See all articles by Sen Dong

Sen Dong

Columbia Business School - Economics Department

Date Written: July 16, 2006

Abstract

Expected exchange rate changes are determined by interest rate differentials across countries and risk premia, while unexpected changes are driven by innovations to macroeconomic variables, which are amplified by time-varying market prices of risk. In a model where short rates respond to the output gap and inflation in each country, I identify macro and monetary policy risk premia by specifying no-arbitrage dynamics of each country's term structure of interest rates and the exchange rate. Estimating the model with US/German data, I find that the correlation between the model-implied exchange rate changes and the data is over 60%. The model implies a countercyclical foreign exchange risk premium with macro risk premia playing an important role in matching the deviations from Uncovered Interest Rate Parity. I find that the output gap and inflation drive about 70% of the variance of forecasting the conditional mean of exchange rate changes.

Keywords: exchange rates, monetary policy rules, term structure models, financial markets and the macroeconomy

JEL Classification: C13, E43, E52, F31, G12, G15

Suggested Citation

Dong, Sen, Macro Variables Do Drive Exchange Rate Movements: Evidence from a No-Arbitrage Model (July 16, 2006). Available at SSRN: https://ssrn.com/abstract=890873 or http://dx.doi.org/10.2139/ssrn.890873

Sen Dong (Contact Author)

Columbia Business School - Economics Department ( email )

420 West 118th Street
New York, NY 10027
United States

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