Exchange Rates, Risk Premia and Inflation-indexed Bond Yields

Richard Clarida and Shaowen Luo

Drawing on, and extending, Clarida (2012; 2013) and Luo (2013), this chapter derives and empirically estimates a structural relationship between the nominal exchange rate, national price levels and observed yields on long-maturity inflation-indexed bonds. This relationship can be interpreted as defining the fair value of the exchange rate that will prevail in any model or real world economy in which inflation-indexed bonds are traded. “Fair value” is the level of the nominal exchange rate that equates the known real return to holding a long-maturity home currency inflation-indexed bond to the expected real return, to holding an inflation-indexed bond payable in foreign currency. We derive a novel, empirically observable real-time measure of the risk premium that can open up a wedge between the observed level of the nominal exchange rate and its fair value, and relate our measure of the long horizon real risk premium to the Fama (1984) measure of the short horizon nominal risk premium.

We take our theory to a daily dataset spanning the period January 2001–February 2011, and study high-frequency, real-time decompositions of pound, euro and yen exchange rates into their fair value