A Habit‐Based Explanation of the Exchange Rate Risk Premium

Abstract

This paper presents a model that reproduces the uncovered interest rate parity puzzle. Investors have preferences with external habits. Countercyclical risk premia and procyclical real interest rates arise endogenously. During bad times at home, when domestic consumption is close to the habit level, the representative investor is very risk averse. When the domestic investor is more risk averse than her foreign counterpart, the exchange rate is closely tied to domestic consumption growth shocks. The domestic investor therefore expects a positive currency excess return. Because interest rates are low in bad times, expected currency excess returns increase with interest rate differentials. Copyright (c) 2009 the American Finance Association.

Speculative capital and currency carry trades

“…Eichenbaum, and Rebelo (2009), Burnside, Han, Hirshleifer, and Wang (2010), Plantin andShin (2010), andVerdelhan (2010). 6 Finally, our paper is also related to the hedge fund literature.…”

International Diversification Benefits with Foreign Exchange Investment Styles*

“…11 See, for instance, Lustig and Verdelhan (2007), Bacchetta and van Wincoop (2010), Christiansen, Ranaldo, and Söderlind (2010), Lustig, Roussanov, and Verdelhan (2010), Verdelhan (2010), Burnside, Eichenbaum, Kleshchelski, and Rebelo (2011), Burnside, Han, Hirshleifer, andWang (2011), Menkhoff, Sarno, Schmeling, andSchrimpf (2011), for recent contributions. Schrimpf, 2010).…”

Discussion of “The Swiss Franc Exchange Rate and Deviations from UIP: Global versus Domestic Factors” by Mathias Hoffmann and Rahel Suter

“…The Hoffmann and Suter paper is built on a theoretical model first developed in Verdelhan (2010) and later expanded in Lustig and Verdelhan (2007). The thread in these works is that excess returns from carry trade portfolios across currencies can be explained by a version of the consumption-based capital asset pricing model (C-CAPM).…”