Publication: The forward premium anomaly : can sticky-price models generate volatile foreign exchange risk premia?
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2007-05
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Abstract
Fama’s (1984) volatility relations show that the risk premium in foreign exchange
markets is more volatile than, and is negatively correlated with the expected rate of
depreciation. This paper studies these relations from the perspective of goods markets
frictions. Using a sticky-price general equilibrium model, we show that near-random
walk behaviors of both exchange rates and consumption, in response to monetary
shocks, can be derived endogenously. Based on this approach, the paper provides
quantitative results that might explain the forward premium anomaly, which is one of
the most important puzzles in international finance.
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Keywords
Foreign exchange risk premium, Forward premium anomaly, Random walk behaviors, Staggered price setting, Interest-sensitive money demand, Monetary shocks