DP635 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, Risk Aversion
JEL(s):	F31, G12, G15
Programme Areas:	International Macroeconomics
Link to this Page:	cepr.org/active/publications/discussion_papers/dp.php?dpno=635

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.