Exchange-Rate Risk and Business Cycles
Lloyd, S. P.
Marin, E. A.
Cambridge Working Papers in Economics
Cambridge-INET Working Paper Series
Faculty of Economics, University of Cambridge
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Lloyd, S. P., & Marin, E. A. (2019). Exchange-Rate Risk and Business Cycles. https://doi.org/10.17863/CAM.79583
We show that currencies with a steeper yield curve depreciate at business-cycle horizons. We identify a tent-shaped relationship between exchange-rate risk premia (ERRP) and the relative yield curve slope across horizons that peaks at 3-5 years and is robust to a number of controls, including liquidity yields. Within a no-arbitrage framework, ERRP reflect investors' changing return valuations over the business cycle. We calibrate a two-country, two-factor model of interest rates, where exchange rates are driven by business-cycle - transitory and cyclical - risk. The model quantitatively reproduces the tent-shaped relationship, as well as variation in uncovered interest parity coefficients across horizons.
Business-cycle risk, Exchange rates, Risk premia, Stochastic discount factor, Uncovered interest parity, Yield curves
This record's DOI: https://doi.org/10.17863/CAM.79583
This record's URL: https://www.repository.cam.ac.uk/handle/1810/332137
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