Durable Long Run Risk Models:Evidence From Currency Markets

According to the uncovered interest rate parity (UIP) condition, risk neutral and rational investors would expect the foreign currency to depreciate against the national currency when the foreign interest rate is higher than the national interest rate. The depreciation rate is just the interest rate difference between the two countries and thus investors will earn a zero return in excess of the national interest rate by the way that borrows at home and lends at abroad. However, higher foreign interest rate usually means a higher excess return in the currency markets. In the thesis, the violation of the UIP condition phenomenon in the currency markets is studied. We construct eight foreign currency portfolios on the basis of foreign interest rate and study the excess return of the portfolios. The excess return on the higher interest rate portfolio is higher than the low interest rate portfolio and we want to explain the different excess returns between the different portfolios. An independent volatility shock is introduced to the existing durable long run risk model and the improved durable long run risk model can better explain the currency risk premium between the different portfolios. In DLRR model, news about consumption has an impact on long erm expected growth rates or economic uncertainty. With the use of Fama-MacBeth two-stage procedure and ’out of sample’ procedure, we find that the improved durable long run risk model can get a significant risk premium. Our model can better explain the risk premium between different portfolios than other models. Durable consumption shock is very important in explaining the currency risk premium. Furthermore, our durable long run risk model can get a reasonable risk preference parameter. For ’out of sample’ prediction, our durable long run risk model can better predict the currency returns by average pricing errors. The prediction ability of durable long run risk model is similar to other models by mean squared pricing errors, which is similar to the prediction ability of long run risk model in stock markets. In all, the currency risk premium is well explained by our durable long run risk model.