Breaking Parity: Equilibrium exchange rates and currency premia

Abstract

Breaking Parity: Equilibrium exchange rates and currency premia

The authors propose a partial equilibrium model of frictional currency intermediation to derive an empirical framework that explains the joint behavior of interest rates, currency premia and spot and forward exchange rates, both in the cross section of currencies and in the time series for individual currencies. In the cross section, the excess supply of local-currency savings is the key determinant of low relative interest rates, negative covered and uncovered currency premia, expensive currency forwards; and vice versa. In the time series,  covered currency premia change in concert driven by aggregate financial market conditions. In contrast, uncovered currency premia move frequently in response to idiosyncratic currency demand shocks which we capture with the dynamics of net currency futures positions of dealer banks. Sharp spot exchange rate movements accommodate the equilibrium dynamics of predictable currency returns necessary to ensure intermediation of currency demand shocks, irrespective of their origin. Changes in the net currency futures positions of dealer banks account for most of the variation in the spot exchange rate for every currency.

Oleg Itskhoki

Oleg Itskhoki is moving to the Department of Economics at Harvard University, after holding the Venu and Ana Kotamraju Endowed Chair in Economics at the University of California, Los Angeles, and previously a Professor of Economics and International Affairs at Princeton University. He is a Fellow of the Econometric Society, an NBER research associate, a CEPR research affiliate, and an associate editor of the American Economic Review. His research interests are in macroeconomics and international economics, where he studies globalization and labor markets, and currencies, exchange rates and international relative prices, as well as other topics.

He holds a BA in economics from Moscow State University, an MA in economics from the New Economic School, and a PhD in economics from Harvard University. He is the 2022 John Bates Clark Medalist, a participant of the Review of Economic Studies Tour, a Sloan Research Fellow, a recipient of the Excellence Award in Global Economic Affairs from the Kiel Institute for the World Economy, and was on the IMF’s list of 25 influential economists under the age of 45.