A Model of FX Fluctuations with News
15 Pages Posted: 14 Sep 2015
Date Written: September 2015
Abstract
A forward looking model of the value of a currency, analogue to the present value model of stock prices, as in Lyons (2001) is extended to provide a solution of the dynamics of FX in terms of: the lagged yield differential as per uncovered interest parity (UIP), news about yield differentials expected in the future, and news about the long-run exchange rate. This solution provides a link between carry models and fundamental/long-run FX models, and a theoretical foundation to some empirical modeling of FX in the literature. A simple time-series model for the yield differential provides a closed-form solution that illustrates deviations from UIP, exploiting how the persistence of the differential predicts its response to shocks. Using the simple time-series model for each yield instead, provides a closed-form solution that illustrates how UIP deviations can occur even when current home and abroad yield shocks offset each other due to the different persistence of yields that implies different future expected paths.
Keywords: Currency valuation, FX dynamics, news to yields, deviations from uncovered interest parity.
JEL Classification: F31, G12
Suggested Citation: Suggested Citation