DP12893 Multihorizon Currency Returns and Purchasing Power Parity

Author(s): Mikhail Chernov, Drew Creal
Publication Date: April 2018
Date Revised: October 2018
Keyword(s): affine term structure model, cointegration, multiple horizons, purchasing power parity, uncovered interest parity
JEL(s): F31, F47, G12, G15
Programme Areas: Financial Economics, International Macroeconomics and Finance
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=12893

Exposures of expected future depreciation rates to the current interest rate differential violate the UIP hypothesis in a distinctive pattern that is a non-monotonic function of horizon. Conversely, forward, risk-adjusted expected depreciation rates are monotonic. We explain the two patterns by incorporating the weak form of PPP into a no-arbitrage joint model of the depreciation rate, inflation differential, domestic and foreign yield curves. Short-term departures from PPP generate the first pattern. The risk premiums for these departures generate the second pattern.