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Get Real: Interpreting Nominal Exchange Rate Fluctuations

Get Real: Interpreting Nominal Exchange Rate Fluctuations

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This paper derives a structural relationship between the nominal exchange rate, national price levels, and observed yields on long-maturity inflation-indexed bonds.
This paper derives a structural relationship between the nominal exchange rate, national price levels, and observed yields on long-maturity inflation-indexed bonds.

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Published by: Alternative Economics on Apr 23, 2012
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Get Real: Interpreting Nominal Exchange RateFluctuations
Richard Clarida
Columbia UniversityThis paper derives a structural relationship between thenominal exchange rate, national price levels, and observedyields on long-maturity inflation-indexed bonds. This rela-tionship can be interpreted as defining the (conditional) risk-neutral fair value of the exchange rate between two countriesin which inflation-indexed bonds are issued. We derive a novel,empirically observable measure of the risk premium that canopen up a wedge between the observed level of the nominalexchange rate and its risk-neutral fair value. We relate ourmeasure of the risk premium reflected in the level of the nom-inal exchange rate to the familiar Fama measure of the riskpremium reflected in rates of return on foreign currency invest-ments. We take our theory to a data set spanning the periodJanuary 2001–February 2011 and study high-frequency, real-time decompositions of pound, euro, and yen exchange ratesinto their risk-neutral fair value and risk premium components.The relative importance of these two factors varies dependingon the subsample studied. However, subsamples in which, con-trary to the Meese-Rogoff (1983) puzzle, 30 to 60 percent of the fluctuations in daily exchange rate changes are explainedby contemporaneous changes in risk-neutral fair value are notuncommon.JEL Codes: F31, F32, F37.
The author is the C. Lowell Harriss Professor of Economics, Columbia Uni-versity and Global Strategic Advisor, PIMCO. This paper was prepared for theApril 22–23, 2011 conference in honor of Benjamin Friedman hosted by the Fed-eral Reserve Bank of Boston. I am indebted to Ben Friedman for so much, notleast for providing me with the deep and lasting foundations to do to research inmonetary economics, and for teaching me that good economics is more about thequestions we seek to answer and not so much about the methodologies we seekto promote. Thank you, Ben.
175
 
176 International Journal of Central Banking January 2012
1. Introduction
This paper derives a structural relationship between the nominalexchange rate, national price levels, and observed yields on long-maturity inflation-indexed bonds. This relationship can be inter-preted as defining the risk-neutral fair value of the exchange ratethat will prevail in any model—or, more importantly, any real-world economy—in which inflation-indexed bonds are traded. Theadvantage of this approach is that it does not impose restrictiveassumptions (e.g., complete markets, representative agent) on finan-cial market equilibrium, does not require the estimation of a stablelinear time-series model for short-term ex ante real interest differen-tials or expected future inflation, nor does it require that the expec-tations hypothesis of the term structure hold. We derive a novel,empirically observable measure of the risk premium that can openup a wedge between the observed level of the nominal exchange rateand its risk-neutral fair value. We relate our measure of the riskpremium reflected in the level of the nominal exchange rate to thefamiliar Fama (1984) measure of the risk premium reflected in ratesof return on foreign currency investments.We take our theory to a data set spanning the period January2001–February 2011 and study high-frequency, real-time decomposi-tions of pound, euro, and yen exchange rates into their risk-neutralfair value and risk premium components. The relative importanceof these two factors varies depending on the subsample studied.However, subsamples in which, contrary to the Meese-Rogoff (1983)puzzle, 30 to 60 percent of the fluctuations in daily exchange ratechanges are explained by contemporaneous changes in risk-neutralfair value are not uncommon.
2. The Model
We make a minimal number of assumptions. We do not assumecomplete markets or a representative agent. We do not assume thatwe know the model, let alone the parameters, that link the presentvalue of macro fundamentals to exchange rate valuation. Under ourassumptions, our framework is consistent with almost any underly-ing model. We assume that, in a global financial equilibrium, thereis a functional relationship between the nominal (U.S. dollar) price
 
Vol. 8 No. S1 Get Real: Interpreting Nominal Exchange Rate 177
today of an asset that delivers a random dollar cash flow at somedate in the future (for concreteness, ten years hence) and no cashflow at any date other than
t
+
n
:
ρ
t
=
t
(
t
+
n
;Ω
t,t
+
n
)
,
where Ω
t,t
+
n
is the conditional probability distribution of the ran-dom nominal cash flow from the asset that pays off in
n
years. Wespecialize
so that
ρ
t
=
t
(
m
t,n
t
+
n
;Ω
t,t
+
n
)
.
(1)So today’s price of an asset with random nominal cash flow in
n
years is the conditional expectation of the product of that cash flowand the random variable
m
t,n
.
Assumption.
m
t,n
is homogenous in the price levels
t
and 
t
+
n
.
m
t,n
=
z
t,n
t
t
+
n
(2)This is a standard property in many asset pricing models. Forexample, in Lucas (1982),
m
t,n
=
β 
n
(
t
+
n
)
(
t
)
t
t
+
n
.
Again, we do not require a representative agent, complete markets,or really any additional structure on
z
t,n
. This is an intuitive restric-tion on nominal asset prices that says that the
real 
price of the assettoday depends upon the
real 
value of the cash flow it delivers stateby state at maturity and not the price level itself at
t
+
n
itself (after,of course, controlling for factors other than the price level itself thatare included in
z
t,n
).With this background, consider how to price a zero-couponinflation-indexed bond that pays off one dollar in
n
years multipliedby cumulative realized inflation over the next
n
years.
ρ
t
=
t
m
t,n
·
1
·
t
+
n
t
=
t
(
z
t,n
·
1) (3)

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