A Theory of Exchange Rates and the Term Structure of Interest Rates

• Author: Hyoung‐Seok Lim,Masao Ogaki
• Published date: 01 February 2013
• Date: 01 February 2013
• DOI: http://doi.org/10.1111/rode.12016

A Theory of Exchange Rates and the Term Structure

of Interest Rates

Hyoung-Seok Lim and Masao Ogaki*

Abstract

This paper defines the concepts of indirect and direct risk premium effects and analyzes their properties in

an exchange rate model. In the model,these effects are endogenously determined in a rational expectations

equilibrium. For the effect of an interest rate shock, they have the opposite signs and the indirect risk

premium effect can dominate the direct risk premium effect under reasonable parameters.This means that

domestic short-term bonds and foreign bonds are complements in the model even though domestic long-

term bonds and foreign bonds are substitutes.This model, focusing on the indirect risk premium effect and

on the term structure of interest rates, can be combined with a small sample bias approach to explain styl-

ized facts about the forward premium anomaly, which is found for short-term interest rates, but not for

long-term interest rates.

1. Introduction

Uncovered Interest Parity (UIP) states that the interest rate return on a domestic cur-

rency asset should equal the interest rate on each foreign currency asset, less the

expected appreciation of the domestic currency. However, contrary to what UIP

would predict, many empirical findings about short-term interest rates have shown

that currencies with high interest rates tend to appreciate. This is called the forward

premium anomaly. On the other hand, more favorable evidence for UIP has been

found for long-term interest rates.

This paper defines the concept of an indirect risk premium effect and analyzes

properties of this effect in an exchange rate model. To investigate the role of the indi-

rect risk premium effect in explaining the stylized facts mentioned above, we build a

partial equilibrium model of exchange rate determination for a small open economy.

The domestic investors have a constant absolute risk aversion utility function over

their wealth in the next period. The asset returns are normally distributed condition-

ally on the available information. We assume that there are three assets in the model:

one risk free asset – domestic short-term bonds; and, two risky assets – domestic long-

term bonds and foreign bonds. The investors are also assumed to have a short invest-

ment horizon in our model. Employers of professional traders active in foreign

exchange markets are likely to assess traders based on their short-horizon perform-

ances.Therefore, our short investment horizon assumption is justifiable.

Given the conditional expectations and variances of all risky assets, we can decom-

pose the effect of a change in the domestic short-term interest rate on the demand for

* Lim: Korea Institute of Finance, MyungDong, Chung-Gu, Seoul 100-021, Korea. Tel: 82-2-3705-6354;

Fax: 82-2-3705-6285; E-mail: hslim@kif.re.kr. Ogaki: (corresponding author): Department of Economics,

Keio University, 2-15-45 Mita, Tokyo 108-8345, Japan. Tel: 81-3-5418-6403; Fax: 81-3-5427-1578; E-mail:

mogaki@econ.keio.ac.jp. We gratefully acknowledge the very helpful comments from Paul Evans, Lars

Hansen, Pok-sang Lam,Nelson Mark, Masaya Sakuragawa, and two anonymous referees,as well as seminar

participants at Ohio State University and the University of Rochester. Ogaki’s research is supported by

Grants-in-Aid for Scientific Research (B) 22330062.

Review of Development Economics, 17(1), 74–87, 2013

DOI:10.1111/rode.12016

© 2013 Blackwell Publishing Ltd