Abstract:
We examine the behavior of forward and spot exchange rates from the perspective of the representative agent theory of asset pricing. We verify that with moderate risk aversion and time-additive preferences the theory accounts for very little (by our calculations, less than 5 percent) of the variability of expected returns from currency speculation observed for major currencies versus the U.S. dollar. With strong habit persistence, however, the theory can account for one-half to two-thirds of the estimated standard deviation of expected returns from currency speculation. Hansen-Jagannathan bounds imply that the variability of expected returns on currencies, like the equity premium, requires a great deal of variability in intertemporal marginal rates of substitution, some of which is delivered by habit persistence.