Lloyd, S. P. and Marin, E. A.
Exchange Rate Risk and Business Cycles
CWPE1996
Abstract: We show that currencies with a steeper yield curve depreciate at business-cycle horizons. We identify a tent-shaped relationship between exchange-rate risk premia (ERRP) and the relative yield curve slope across horizons that peaks at 3-5 years and is robust to a number of controls, including liquidity yields. Within a no-arbitrage framework, ERRP reflect investors' changing return valuations over the business cycle. We calibrate a two-country, two-factor model of interest rates, where exchange rates are driven by business-cycle - transitory and cyclical - risk. The model quantitatively reproduces the tent-shaped relationship, as well as variation in uncovered interest parity coefficients across horizons.
Keywords: Business-cycle risk, Exchange rates, Risk premia, Stochastic discount factor, Uncovered interest parity, Yield curves
JEL Codes: E43 F31 G12
Author links:
PDF: https://www.econ.cam.ac.uk/research-files/repec/cam/pdf/cwpe1996.pdf 
Open Access Link: https://doi.org/10.17863/CAM.79583
Keynes Fund Project(s):
Inefficient Capital Flows and the Hegemon’s Dilemma (JHUK)