Exchange Rate Economics: Theories and Evidence

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Spot and forward exchange rates 377 The earlier relationships can be used to re-express the Fama result that the variance of the risk premium is greater than the variance of the expected change in the exchange rate – var(λ t ) is > var(E t s t+k − s t ) as: Var{E t (Q ∗ t+1 /Q t+1) −[E t (Q ∗ t+1 )/E t(Q t+1 )]} > Var{E t (Q ∗ t+1 /Q t+1)}. (15.19) In words,expression (15.19) indicates that the risk premium is the difference between the ratio of expected marginal rates of substitution in consumption and the expectation of this ratio and the variance of this difference exceeds the variance of the expected ratio of marginal rates of substitution. From (15.15),and by exploiting the CIP condition,a further implication of (15.15) is ( ) S t+1 − F t E t Q t = 0,(15.20) S t which may be rewritten to give an alternative interpretation of the forward premium as: ( ) ( St+1 − F t E t = Cov Q t ; S ) t+1 − F t |I t [−E t (Q t )] −1 ,(15.21) S t S t or ( ) ( F t St+1 = E t − Cov Q t ; S ) t+1 − F t |I t [−E t (Q t )] −1 , S t S t S t where the risk premium is the second term on the right hand side and this clearly implies that the forward rate need not be an unbiased predictor of the future spot rate. Note that in this model this biasedness result can occur even with risk-neutral agents,a situation characterised by the linearity of the utility function underlying (15.21). 15.3.2 Testing the general equilibrium risk premium model A number of researchers have empirically implemented the general equilibrium approach to modelling the risk premium and we consider the various tests in this subsection. 15.3.2.1 Direct (error orthogonality) tests Mark (1985) considers a variant of equation (15.15),in which the return is defined as the forward forecast error: 2 ( ) S t+1 − F t E t Q t = 0. (15.22) S t
378 Spot and forward exchange rates In order to estimate (15.22) the utility function has to be explicitly parameterised and Mark uses a constant relative risk aversion (CRRA) utility function of the form: U (C t ) = δC 1−γ t /(1 − γ), γ
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Exchange Rate Economics Exchange Ra
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Firstpublished2007 by Routledge 2Pa
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Contents List of figures List of ta
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Figures 1.1 The balance of payments
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Figures 13.6 Fourth generation spec
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Preface This book is the second edi
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2 Introduction Although the textboo
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4 Introduction (orders to buy/sell
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6 Introduction Table 1.3 Currency d
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8 Introduction a truly flexible exc
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10 Introduction this has to be sati
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12 Introduction likely that the rel
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14 Introduction or F (1 + i) = S (1
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16 Introduction Consider now a fall
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18 Introduction The empirical evide
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20 Introduction (mean and variance)
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22 Introduction (a) (b) 0.3 0.25 0.
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24 Introduction clusters or that it
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26 Introduction 0.1 0.05 0 -0.05 -0
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28 Introduction 1.9 Exchange rate r
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30 Introduction fixed versus flexib
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32 Introduction influences. For exa
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34 Introduction 1.11 The determinan
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36 Introduction In the standard OCA
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38 Introduction most transactions i
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40 Purchasing power parity and the
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3 The economics of the PPP puzzle I
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70 The economics of the PPP puzzle
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4 The flexible price monetary appro
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96 The flexible price monetary appr
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98 The flexible price monetary appr
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100 The flexible price monetary app
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5 The sticky-price monetary model I
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108 The sticky-price monetary model
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6 The monetaryapproach to the excha
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136 Empirical evidence on the monet
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Table 6.5 SEM equations: United Kin
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7 Currencysubstitution models and t
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168 Currency substitution and portf
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200 Real exchange rate determinatio
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228 Equilibrium exchange rates rate
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230 Equilibrium exchange rates A nu
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232 Equilibrium exchange rates long
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234 Equilibrium exchange rates 5.1
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236 Equilibrium exchange rates term
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238 Equilibrium exchange rates 0.30
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240 Equilibrium exchange rates Detk
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242 Equilibrium exchange rates US i
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244 Equilibrium exchange rates The
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246 Equilibrium exchange rates 9.6.
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248 Equilibrium exchange rates 9.6.
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250 Equilibrium exchange rates Conc
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252 The new open economy macroecono
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11 The new open economy macroeconom
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290 Target zone models 12.1 The bas
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292 Target zone models stochastic c
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294 Target zone models moves from 2
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296 Target zone models where A 1 an
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298 Target zone models expected dev
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300 Target zone models % expected d
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302 Target zone models MacDonald (2
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304 Target zone models for the DM-l
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306 Target zone models explicit ban
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308 Target zone models Table 12.1 F
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310 Target zone models short-term i
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312 Target zone models the UK short
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314 Speculative attack models and c
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Page 341 and 342: 326 Speculative attack models and c
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Page 421 and 422: 406 References Artis,M. and M. Lewi
Page 423 and 424: 408 References Bergin,P.,R. Glick a
Page 425 and 426: 410 References Calvo,G.A. and C.A.
Page 427 and 428: 412 References Clark,P.B. and R. Ma
Page 429 and 430: 414 References Detken,C.,A. Dieppe,
Page 431 and 432: 416 References Edwards,S. and I. Ma
Page 433 and 434: 418 References Fischer,S. (2001),
Page 435 and 436: 420 References Frieden,J.P.G. and E
Page 437 and 438: 422 References Granger,C.W. and T.
Page 439 and 440: 424 References Hooper,P. and J. Mor
Page 441 and 442: 426 References Kearney,C. and R. Ma
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428 References Lewis,K. (1988),‘T
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430 References MacDonald,R. (2002),
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432 References Mark,N.C. (2001),Int
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434 References Obstfeld,M. and K. R
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436 References Roll,R. (1979),‘Vi
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438 References Tauchen,G.E. and M.
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Index Abadir,K. 389 Abuaf,N. 60 Adl
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442 Index Diba,B. 177-8 Dickey,D.A.
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444 Index Gagnon,J. 212 Gali,J. 128
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446 Index Miller,M.H. 120,123,128,1
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448 Index purchasing power parity (
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450 Index trade: interbank trade 34
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Exchange Rate Economics: Theories and Evidence

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