Multihorizon Currency Returns and Purchasing Power Parity

Abstract

Exposures of expected future depreciation rates to the current interest rate differential violate the UIP hypothesis in a distinctive pattern that is a non-monotonic function of horizon. Conversely, forward, or risk-adjusted expected depreciation rates are monotonic. We explain the two patterns jointly by incorporating the weak form of PPP, aka stationarity of the real exchange rate, into a joint model of the stochastic discount factor, the nominal exchange rate, inflation differential, domestic and foreign yield curves. Short-term departures from PPP generate the first pattern. The risk premiums for these departures generate the second pattern. Thus, the variance of the stochastic discount factor must be related to the real exchange rate deepening the exchange rate disconnect.

Puzzling Exchange Rate Dynamics and Delayed Portfolio Adjustment

“…Regarding ψ and γ, we set them at respectively 15 and 50 in the benchmark and will vary them over a large range to consider sensitivity. 17 These benchmark values are consistent with evidence regarding both the second-order difference equation (11) for the exchange rate and the portfolio expression (8). Regarding ( 11 The portfolio expression (8) relates the portfolio share at time t to the portfolio share at t − 1 and the expected excess return, with coefficients of respectively 0.998 and 0.066 under the benchmark paramaterization.…”

“…A higher γ leads to both less portfolio persistence and weaker return sensitivity, while a higher ψ raises portfolio persistence, but weakens return sensitivity. 11 There is an analogous solution for the Foreign country giving the optimal fraction invested in Foreign bonds by Foreign investors z * t . By symmetry, the steady state fraction invested in Foreign bonds for Foreign investors isz * = 1 −z.…”

“…Engel (2016), Itshkoki and Mukhin (2017), and Vlachev (2017) propose explanations based on liquidity shocks. Chernov and Creal (2018) and Dahlquist and Penasse (2017) focus on the role of long-term real exchange rate adjustment. The forward guidance exchange rate puzzle and LSV puzzle have only been recently documented and no solution has been proposed yet.…”

“…Chernov and Creal (2018) andDahlquist and Penasse (2017) argue that there is a missing risk premium that should be related to the real exchange rate. Their proposed specification is however different from ours in equation(12).…”

Puzzling exchange rate dynamics and delayed portfolio adjustment

“…Engel (2016), Itshkoki and Mukhin (2017), and Vlachev (2017) propose explanations based on liquidity shocks. Chernov and Creal (2018) and Dahlquist and Penasse (2017) focus on the role of long-term real exchange rate adjustment. The forward guidance exchange rate puzzle and LSV puzzle have only been recently documented and no solution has been proposed yet.…”