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The Cambridge-INET Institute - continuing as the Janeway Institute

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Lloyd, S. P. and Marin, E. A.

Exchange Rate Risk and Business Cycles

WP Number: 1922

Abstract: 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.

Keywords: Business-cycle risk, Exchange rates, Risk premia, Stochastic discount factor, Uncovered interest parity, Yield curves

JEL Codes: E43 F31 G12

Author links:

PDF: wp1922.pdf

Open Access Link: 10.17863/CAM.79583

Keynes Fund Project(s):
Inefficient Capital Flows and the Hegemon’s Dilemma (JHUK)  

Theme: transmission