Working Paper: NBER ID: w27844
Authors: Kimberly A. Berg; Nelson C. Mark
Abstract: We study international currency risk in a two-country dynamic stochastic general equilibrium model under incomplete markets. The underlying sources of risk are direct shocks to productivity growth, shocks to a long-run risk component of productivity growth, shocks to a stochastic volatility component of productivity growth, and shocks to monetary policy. The long-run risk and stochastic volatility shocks have the interpretation of aggregate demand shocks. Cross-country heterogeneity in the model arises from three sources: differences in the long-run risk and stochastic volatility process parameters that we estimate using United States and Japanese total factor productivity data, differences in monetary policy parameters, and differences in export pricing. The driving force behind currency risk is heterogeneity in precautionary saving. Differences in monetary policy can generate moderate currency risk, but structural differences in productivity growth are more important. Export pricing conventions are not important sources of currency risk. Stochastic volatility shocks are key to generating volatility in the currency risk premium, but they do not help at all in explaining the forward premium bias/anomaly.
Keywords: currency risk; monetary policy; productivity growth; dynamic stochastic general equilibrium; forward premium bias
JEL Codes: E21; E43; F31; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| differences in monetary policy (E52) | currency risk (F31) |
| structural differences in productivity growth (O49) | currency risk (F31) |
| stochastic volatility shocks (C58) | currency risk premium (F31) |
| stochastic volatility shocks (C58) | forward premium bias anomaly (G17) |
| Japan’s productivity growth is more volatile than that of the United States (O49) | currency risk (F31) |
| procyclical monetary policy in Japan (E52) | precautionary saving among U.S. residents (D14) |
| precautionary saving among U.S. residents (D14) | investment in U.S. dollar-denominated bonds (G15) |
| forward premium bias anomaly (G17) | currency risk premium (F31) |