The Country and Exchange Risk Premium with the Euro Area and the U.S. Based on Price Parity Models PDF Download

Author: Bok-Keun Yu
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Languages : en
Pages : 92

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Book Description
The main objective of this dissertation is to explore the country risk premium and exchange risk premium based on the price parity models for the developed and Asian emerging market countries against two large open economies, the Euro Area and the US, since the introduction of the euro in 1999. Traditionally, the US dollar has been used as the "foreign" currency. But since the emergence of the euro, both of these currencies have been playing major roles as the main currency for trading assets in global financial markets. Hence we believe that it is meaningful to compare interest rate differentials constructed from these two major currencies. In Chapter 1, we conduct surveys on the related literature and important stylized facts. In the literature review section, we carefully look at the empirical results and interpretations regarding the covered interest differentials (CIDs) and covered interest parity (CIP), forward rate puzzle, and uncovered interest differentials (UIDs) and uncovered interest parity (CIP). Next, we preview some characteristics of short-term nominal government bond yields, and examine similarities between the nominal government bond yields and the central banks' key rates in 4 major currency economies (Euro Area, US, UK, Japan). We briefly investigate the establishment and development of the EMU and the characteristics and differences of monetary policies in the ECB and the Fed. We also foresee the trends and changes in exchange rates, amounts outstanding in international bonds and notes, and official foreign exchange reserves in 4 major currencies. In Chapter 2, we specify the empirical model, and discuss the empirical results such as interest differentials, the country and exchange risk premium, the relationship between the exchange risk premium and UIDs, and nonstationarity and long-run equilibrium relationship. The important empirical results of this dissertation are summarized in the following paragraphs. The US short-term bond carries a lower risk than the Euro Area bond in view of the country risk premium. We find that the country risk premium itself is quantitatively small, and identify that a major source of interest differentials is the exchange risk premium in most countries. From the analysis on the exchange risk premium, we can infer that the US dollar is preferred to the euro as a financial asset in spite of its depreciation against other major currencies since 2002. The cointegration analysis shows that the CIP data series can be regarded as a long-run equilibrium relationship in some countries, but the UIP data series are not without proper adjustment of a time-varying exchange risk premium in almost all countries. Through our empirical analysis, we can confirm that most of the exchange risk premium is closely related to interest differentials which come mostly from differences in the monetary policy stance in each country. Our findings provide some evidence that the US has been more aggressive in the business cycles during the period analyzed, while other countries, including the Euro Area, were more prudent. Thus, this paper suggests that monetary policies combined with macroeconomic conditions for different countries are important in understanding interest differentials, especially in light of exchange rate risks.