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MACROECONOMIC SHOCKS AND THE FOREIGN EXCHANGE RISK PREMIA

Published online by Cambridge University Press:  23 August 2006

SHIGERU IWATA  and
SHU WU
SHIGERU IWATA
Affiliation:
University of Kansas
SHU WU
Affiliation:
University of Kansas
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Abstract

In this paper we empirically examine the sources of the volatility of the foreign exchange risk premia. Using a nonlinear structural Vector Autoregression (VAR) model based on no-arbitrage condition to identify various macroeconomic shocks and the foreign exchange risk premia, we find that more than 80% of the volatilities of the currency risk premia can be accounted for by the standard macroeconomic shocks that drive output and inflation. By explicitly modelling the currency risk premia in the VAR system, we also offer a potential reconciliation for the seemingly contradicting observations from the previous VAR analysis of the exchange rate “overshooting” behavior under exogenous monetary innovations.

Keywords

Macroeconomic ShocksForeign Exchange Risk PremiaNonlinear VARExchange Rate Overshooting
Type
ARTICLES
Information
Macroeconomic Dynamics , Volume 10 , Issue 4 , September 2006 , pp. 439 - 466
Copyright
© 2006 Cambridge University Press

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