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In this study, I formulate a present value model of the exchange rate with a risk premium and introduce exchange rate risk exposure as a factor of the persistently time-varying risk premium. The present value model incorporates expectations for the distant future, and therefore, indicates that spot exchange rate variations reflect changes in long-run future interest rate differential and exchange rate expectations, in addition to a risk premium for long-run risk exposure. I also conduct empirical analyses using mainly the USD/JPY rate and other exchange rates against the USD. The Japanese current account balance provides a better estimation of the change in USD/JPY rate market risk exposure as USD invoiced trades are prevalent in Japan. Then, I demonstrate the possibility that a persistently time-varying risk premium offsets the effect of the interest rate differential on exchange rate variations, which can be a solution to the uncovered interest rate parity puzzle. [ABSTRACT FROM AUTHOR]

Since the Asian financial crisis and the global financial crisis, the regime shift behavior has been notable in the stock markets. We examine the effects of interest rates and foreign exchange rates on stock returns and the cross-correlations of Korean stock returns associated with three other countries: Japan, USA, and China, using the Hamilton 2-regime Markov Switching model, for the period January 1993–December 2016. In both regimes, the volatility in the Korean stock market is greater than Japan and USA, but less than China. In regime 1 with low-volatility, the stock returns of both Korea and Japan are significantly affected first by their exchange rates and then by their interest rates. In regime 2 with high-volatility, the Korean stock market is explained by neither of the two exogenous variables while the Japanese stock returns respond positively to the exchange rates but negatively to the interest rates. The transition probability from regime 1 to regime 2 is greater than the reverse probability in the Korean stock market, which is opposite in Japan. Considering all four countries simultaneously, the Korean stock market is highly influenced by both the US and Japanese stock market in regime 1 with low-volatility, but only influenced by the Japanese stock market in regime 2 with high-volatility. [ABSTRACT FROM AUTHOR]

We revisit a significant research topic on exchange rate behavior by restating the test procedures with an appropriate econometric methodology to re-examine three aspects. (i) Does the inflation (price) factor affect nominal exchange rate? (ii) Do relative interest rates affect a country's exchange rate? (iii) Do the price and interest rate effects hold if controls for non-parity factors are embedded in tests? The quarterly data series for this study are taken over 55 years. The traditional parity condition model with price and interest rate as criterion variables is extended to take into account recently-verified non-parity factors, namely trade, productivity and foreign reserves. The results affirm that both parity factors and also the non-parity factors significantly affect the exchange rates of Canada, Japan, the United Kingdom and the United States. In our view, these findings relating to four free-floating currencies help extend our knowledge on how currency behavior is consistent with parity and non-parity theorems using a relevant methodological approach in this study. [ABSTRACT FROM AUTHOR]

This paper proposes a simple vector autoregressions (VAR) model with (real) output and exchange rate shock on interest rates. Rather than assuming non-recursive identification schemes, we test the identifying assumption of the error term decompositions. Applying the model to quarterly data on major currencies against the U.S. dollar (USD) from 1974 to 1997, interest rate shocks explain--after 3 years--16% of Canadian dollar/USD (CAD) real exchange rate variations and less than 2% for the mark/USD and yen/USD. Positive innovations of interest rates bring about (transitory) CAD real appreciations in differences and (permanent) appreciations in levels. Canadian real output is more explained by domestic interest rate shocks (19%) than Germany's (5) or Japan's (0.2%). Canada is smaller than the other economies and CAD has been shown to suffer from "fear of floating". Our findings support the proposition that domestic output variance under fixed exchange rates. They are also consistent with structural interpretations of the VAR. [ABSTRACT FROM AUTHOR]