Template-Type: ReDIF-Paper 1.0

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: A Habit-Based Explanation of the Exchange Rate
Risk Premium

Abstract: This paper presents a model that reproduces the uncovered interest rate parity
puzzle, based on a time-varying business-cycle related risk premium. Agents have
preferences with external habits. During bad times in the home market, when the
domestic habit is close to domestic consumption level, the exchange rate becomes
more sensitive to domestic than to foreign aggregate consumption growth shocks.
As a result, the foreign currency depreciates in case of a negative consumption
growth shock at home. Hence, investing in foreign currency is risky in bad times,
when domestic interest rates are low relative to foreign interest rates.

Length:  52pages
Creation-Date: 2006-06
Revision-Date: 
Publication-Status:
File-URL: http://people.bu.edu/av/FX_Habits.pdf
File-Format: Application/pdf
File-Function: 
Number: WP2006-047
Classification-JEL: 
Keywords: 
Handle: RePEc:bos:wpaper:WP2006-047