Working Paper: CEPR ID: DP12893
Authors: Mikhail Chernov; Drew Creal
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, risk-adjusted expected depreciation rates are monotonic. We explain the two patterns by incorporating the weak form of PPP into a no-arbitrage joint model of the depreciation 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.
Keywords: Uncovered Interest Parity; Purchasing Power Parity; Cointegration; Multiple Horizons; Affine Term Structure Model
JEL Codes: F31; F47; G12; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| current interest rate differential (IRD) (E43) | expected future depreciation rates (D25) |
| short-term departures from PPP (F31) | nonmonotonic pattern in exposure to the IRD (C22) |
| short-term departures from PPP (F31) | specific patterns in currency returns (F31) |
| real exchange rate (RER) (F31) | variance of the stochastic discount factor (C69) |
| expected future depreciation rates (D25) | currency returns (F31) |
| variance of the stochastic discount factor (C69) | currency risk premiums (F31) |