By Lucio Sarno
This publication is a survey of exchange-rate economics. utilizing the newest econometric recommendations, it covers the most theories that specify the decision of alternate premiums and makes use of contemporary empirical information on alternate expense habit.
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Additional resources for The economics of exchange rates
2 There is still a wedge between the spot and forward rate even in the risk-neutral case. This is because we have log-linearised a nonlinear ﬁrst-order condition. e. φcov t (st+1, ct+1 ). Thus, for the risk premium to explain a signiﬁcant portion of the forward rate forecast error or excess returns, either there must be a very large coefﬁcient of relative risk aversion φ, or consumption must be highly correlated with the exchange rate. The intuition for the fact that high correlation between consumption and the exchange rate raises the risk premium is that forward exchange positions provide less of a hedge against variations in consumption the greater is this covariation.
And since Ct is non-zero, this implies: Et Ft(1) − St+1 Pt+1 1 Ct+1 φ = 0. 49) 2 where lower-case letters denote natural logarithms and vart and cov t denote the conditional variance and covariance based on information at time t. 50) E t st+1 − f t(1) = − vart (st+1 ) + cov t (st+1 , pt+1 ). 2 There is still a wedge between the spot and forward rate even in the risk-neutral case. This is because we have log-linearised a nonlinear ﬁrst-order condition. e. φcov t (st+1, ct+1 ). Thus, for the risk premium to explain a signiﬁcant portion of the forward rate forecast error or excess returns, either there must be a very large coefﬁcient of relative risk aversion φ, or consumption must be highly correlated with the exchange rate.
44); this is because we are considering real returns, so that we can think of the payoff as units of the foreign good, and assuming perfect substitutability between the domestic and foreign good, marginal utilities with respect to the domestic and foreign goods will be identical. 44) we can derive: E t [(rt − rt∗ )UY t+1 /UY t ] = 0. 45) and the fact that E t [(1 + i t )Pt /Ft(1) ] = (1 + i t )Pt /Ft(1) = 0, we can then derive: Et Ft(1) − St+1 UY t+1 Pt+1 UY t = 0. 46) The term (UYt+1 /UYt ) can be thought of as a subjective discount factor, since it values next period’s marginal utility in terms of this period’s marginal utility.
The economics of exchange rates by Lucio Sarno