Foreign exchange rate risk in a small open economy

Working papers set out research in progress by our staff, with the aim of encouraging comments and debate.
Published on 27 February 2009

Working Paper No. 365
By Bianca De Paoli and Jens Søndergaard

Resolving the forward premium puzzle requires a volatile foreign exchange rate risk premium that covaries negatively with the expected depreciation rate. Earlier work has shown how models featuring consumption habits can generate such premia when either trade costs or ‘deep habits’ are assumed. We show that as long as consumption habits are slow-moving and shocks are highly persistent, a standard small open endowment economy — without any additional features — can address the puzzle. Moreover endogenising the labour supply decision in the small open economy can improve the model’s ability to match risk premia observations so long as it makes business cycles less synchronised.

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