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Title: Covered Purchasing Power Parity, Ex-Ante PPP and Risk Aversion

Author(s): Michael J Moore

Publication Date: April 1992

Keyword(s): Arbitrage, Purchasing Power Parity and Risk Aversion

Programme Area(s): International Macroeconomics

Abstract: The standard expectations augmented theory of ex-ante purchasing power parity (PPP), which was first developed by Roll, assumes that agents are risk neutral. A Covered Purchasing Power Condition is developed which holds for the general case of risk aversion. A risk-augmented form of ex-ante PPP is then derived using a Lucas-style asset pricing framework. From this I conclude that real exchange rates may not possess the martingale property though the analysis clarifies the circumstances under which this property does hold.A consumption-based orthogonality condition is tested for, using 1970s and 1980s data for the seven main industrial countries. An interesting by-product of the study is that it provides us with a useful example of unit root testing on seasonal data. Overall the results give rise to cautious optimism.

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Bibliographic Reference

Moore, M. 1992. 'Covered Purchasing Power Parity, Ex-Ante PPP and Risk Aversion'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=635