Working Paper: CEPR ID: DP352
Authors: Paul de Grauwe
Abstract: In this paper we analyze the behavior of the risk premia in exchange markets with very different exchange rate regimes: free floating (dollar markets), the low credibility EMS regime (e.g., Lira/DM and FF/DM) and the high credibility EMS regime (guilder/DM). We find that in the first and the third regime the risk premia behave in similar ways, i.e., they are negatively correlated with expected changes in exchange rates and vary more than expectations about future exchange rate movements. We interpret this evidence as being the result of the existence of a band of "agnosticism" within which movements of current exchange rates have little or no informational content about the market's expectations of future exchange rate movements.
Keywords: foreign exchange markets; risk premia; expectations; EMS; free floating
JEL Codes: 431; 432
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| exchange rate regime (F33) | risk premia (G22) |
| expected changes in exchange rates (F31) | risk premia (G22) |
| forward premium (G13) | future exchange rate changes (F31) |
| risk aversion (D81) | market reactions (G10) |