Working Paper: CEPR ID: DP635
Authors: Michael J. Moore
Abstract: The standard expectations augmented theory of ex-ante purchasing power parity (PPP), which was first developed by Roll, assumes that agents are risk neutral. A Covered Purchasing Power Condition is developed which holds for the general case of risk aversion. A risk-augmented form of ex-ante PPP is then derived using a Lucas-style asset pricing framework. From this I conclude that real exchange rates may not possess the martingale property though the analysis clarifies the circumstances under which this property does hold.A consumption-based orthogonality condition is tested for, using 1970s and 1980s data for the seven main industrial countries. An interesting by-product of the study is that it provides us with a useful example of unit root testing on seasonal data. Overall the results give rise to cautious optimism.
Keywords: purchasing power parity; arbitrage; risk aversion
JEL Codes: F31; G12; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| risk aversion (D81) | traditional ex ante PPP (F31) |
| risk premium (G19) | expected inflation rates (E31) |
| real exchange rates (F31) | risk premiums associated with consumer price index futures (G13) |
| consumption growth rates (F62) | real exchange rates (F31) |
| real exchange rates do not follow martingale process under certain conditions (F31) | martingale property (C73) |
| stationarity of variables (C22) | valid results (C52) |