Bond Risk Premia, Macroeconomic Fundamentals and the Exchange Rate

45 Pages Posted: 19 Feb 2009

Multiple version iconThere are 2 versions of this paper

Date Written: February 13, 2009

Abstract

We introduce a two-country no-arbitrage term-structure model to analyse the joint dynamics of bond yields, macroeconomic variables and the exchange rate. The model allows to understand how exogenous shocks to the exchange rate affect the yield curves, how bond yields co-move in different countries and how the exchange rate is influenced by the interactions between macroeconomic variables and time-varying bond risk premia.

Estimating the model with US and German data, we obtain an excellent fit of the yield curves and we are able to account for up to 75 per cent of the variability of the exchange rate. We find that time-varying risk premia play a non-negligible role in exchange rate fluctuations, due to the fact that a currency tends to appreciate when risk premia on long-term bonds denominated in that currency rise. A number of other novel empirical findings emerge.

Keywords: bond risk premium, exchamge rate, affine model

JEL Classification: G12, G15

Suggested Citation

Pericoli, Marcello and Taboga, Marco, Bond Risk Premia, Macroeconomic Fundamentals and the Exchange Rate (February 13, 2009). Available at SSRN: https://ssrn.com/abstract=1342512 or http://dx.doi.org/10.2139/ssrn.1342512

Marcello Pericoli (Contact Author)

Bank of Italy ( email )

Via Nazionale 91
00184 Roma
Italy

HOME PAGE: http://www.bancaditalia.it

Marco Taboga

Bank of Italy ( email )

Via Nazionale 91
00184 Roma
Italy

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