Risk, Uncertainty and Exchange Rates

61 Pages Posted: 6 Apr 2007 Last revised: 23 Aug 2010

See all articles by Robert J. Hodrick

Robert J. Hodrick

Columbia Business School - Finance and Economics; National Bureau of Economic Research (NBER)

Date Written: November 1987

Abstract

This paper explores a new direction for empirical models of exchange rate determination. The motivation arises from two well documented facts, the failure of log-linear empirical exchange rate models of the 1970's and the variability of risk premiums in the forward market. Rational maximizing models of economic behavior imply that changes in the conditional variances of exogenous processes, such as future monetary policies, future government spending, and future rates of income growth, can have a significant effect on risk premiums in the foreign exchange market and can induce conditional volatility of spot exchange rates. I examine theoretically how changes in these exogenous conditional variances affect the level of the current exchange rate, and I attempt to quantify the extent that this channel explains exchange rate volatility using autoregressive conditional heteroscedastic models.

Suggested Citation

Hodrick, Robert J., Risk, Uncertainty and Exchange Rates (November 1987). NBER Working Paper No. w2429. Available at SSRN: https://ssrn.com/abstract=977738

Robert J. Hodrick (Contact Author)

Columbia Business School - Finance and Economics ( email )

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