Working Paper: NBER ID: w18726
Authors: Richard H. Clarida
Abstract: This paper derives a structural relationship between the nominal exchange rate, national price levels, and observed yields on long maturity inflation - indexed bonds. This relationship can be interpreted as defining the fair value of the exchange rate that will prevail in any model or real world economy in which inflation indexed bonds are traded. An advantage of our derivation is that it does not require restrictive assumptions on financial market equilibrium to be operational. We take our theory to a dataset spanning the period January 2001 - February 2011 and study a daily , real time decompositions of pound, euro, and yen exchange rates into their fair value and risk premium components. The relative importance of these two factors varies depending on the sub sample studied. However, sub samples in which we find correlations of 0.30 to 0.60 between daily exchange rate changes and daily changes in fair value are not uncommon. We also show empirically and justify theoretically that a 1 percent rise in the foreign currency risk premium is on average contemporaneously associated with a 50 basis point rise in the inflation indexed bond return differential in favor of the foreign country and an 50 basis point appreciation of the dollar
Keywords: nominal exchange rates; inflation indexed bonds; risk premium
JEL Codes: F3; F31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Fluctuations in exchange rates (F31) | Changes in fair value and risk premiums (G19) |
| Foreign currency risk premium (F31) | Inflation indexed bond return differential (E31) |
| Foreign currency risk premium (F31) | Nominal exchange rate (Dollar appreciation) (F31) |
| Nominal exchange rate (Dollar appreciation) (F31) | Inflation indexed bond return differential (E31) |