Working Paper: NBER ID: w24563
Authors: Mikhail Chernov; Drew D. 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, 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.
Keywords: Currency Returns; Purchasing Power Parity; Uncovered Interest Parity; Risk Premiums; Exchange Rates
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 |
|---|---|
| expected future depreciation rates (D25) | interest rate differentials (E43) |
| interest rate differentials (E43) | expected future depreciation rates (D25) |
| expected future depreciation rates (D25) | real exchange rate (F31) |
| real exchange rate (F31) | interest rate differentials (E43) |
| forward expected depreciation rates (F31) | real exchange rate (F31) |
| real exchange rate (F31) | risk premiums (G19) |
| risk premiums (G19) | exchange rate disconnect (F31) |
| PPP violations (P37) | adjustment speed of state variables (C32) |