Essays on purchasing power parity and the foreign exchange risk premium

This dissertation consists of three essays that examine the foreign exchange risk premium, the Purchasing Power Parity (PPP) hypothesis, and the relationship between the risk premium and PPP deviations.; The first essay extends the Grinols and Turnovsky (1994) model of exchange rate determination by incorporating stochastic PPP deviations. The behavior of the foreign exchange risk premium is studied assuming that the real exchange rate is a mean-reverting process. The framework leads to a decomposition of the nominal foreign exchange risk premium into expected real return differentials and expected relative PPP deviations.; The second essay develops an optimizing, equilibrium model to explain the forward foreign exchange risk premium as a function of the variances of goods endowments, money supplies, and PPP deviations. PPP deviations are incorporated by assuming symmetric deviations from the law of one price. The equilibrium is calculated through Monte Carlo simulation. Generated risk premia are consistent in magnitude with values observed in the data. It is shown that, for a given variance of money supplies, the risk premium rises significantly with the variance of fluctuations in the real exchange rate.; The third essay examines the PPP hypothesis by testing for unit roots in real exchange rates of OECD countries over the current float. The DF-GLS test of Elliot et al. (1996) and versions of the panel unit root tests of Levin and Lin (1992) and Im, Pesaran, and Shin (1997), modified to eliminate cross-sectional dependence among real exchange rate innovations, are applied. Strong evidence in favor of long-run PPP is found for panels of OECD, European, EC, and EMS countries. The half-lives of PPP deviations are significantly shorter for the EC and EMS panels than the OECD panel. Also, the evidence against the unit root null is stronger when the DM is used as the base currency rather than the dollar.