Template-Type: ReDIF-Paper 1.0

Author-Name: Hanno Lustig

Author-X-Name-First: Hanno 
Author-X-Name-Last: Lustig
Author-Email: 
Author-Workplace-Name: 

Author-Name: Adrien Verdelhan
Author-X-Name-First: Adrien 
Author-X-Name-Last: Verdelhan
Author-Email: av@bu.edu
Author-Workplace-Name: Department of Economics, Boston University

Title: Investing in Foreign Currency is like Betting on
your Intertemporal Marginal Rate of Substitution.


Abstract: Investors earn positive excess returns on high interest rate foreign discount bonds,
because these currencies appreciate on average. Lustig and Verdelhan (2005) show that
investing in high interest rate foreign discount bonds exposes them to more aggregate
consumption risk, while low interest rate foreign bonds provide a hedge. This paper
provides a simple model that replicates these facts. Investing in foreign currency is like
betting on the diŽerence between your own intertemporal; marginal rate of substitution
(IMRS) and your neighbor's IMRS. These bets are very risky if your neighbor's IMRS is
not correlated with yours, but they provide a hedge when his IMRS is highly correlated
and more volatile. If the foreign neighbors that face low interest rates also have more
volatile and correlated IMRS, that accounts for the spread in excess returns in the
data.


Length:  11 pages
Creation-Date: 2005-10
Revision-Date: 
Publication-Status:
File-URL: http://www.bu.edu/econ/workingpapers/papers/Adrien%20Verdelhan/wp2005/Predictability.pdf
File-Format: Application/pdf
File-Function: 
Number: WP2005-040
Classification-JEL: 
Keywords: Exchange Rates, Currency Risk.

Handle: RePEc:bos:wpaper:WP2005-040