FOREX Risk Premia and Policy Uncertainty: A Recursive Utility Analysis

We compare actual and calibrated values for the foreign exchange risk premium based on the definition in Engel (1992). Calibrated values are found from within a dynamic stochastic general equilibrium model of a small open economy consisting of risk-averse optimizing agents with unconventional preferences. We find that the equilibrium foreign exchange risk premium is a function of exogenous shocks in the model and is sensitive to assumed attitudes towards risk. Furthermore, various forms of policy uncertainty improve the capacity of the model to generate values closer to those found in the data. We are grateful for comments from an anonymous referee and the participants at conferences of the European Financial Management Association (EFMA), Lugano 2001 and Money Macro and Finance research group (MMF), Belfast 2001; and seminar participants at the University of Manchester and the Judge Institute of Management Studies, University of Cambridge. Lynne Evans acknowledges support from the Economic and Social Research Council (Award Reference: L138 25 1026). Corresponding author: at School of Economics Finance and Business, University of Durham, 23-26 Old Elvet, Durham DH1 3HY, United Kingdom. Tel: +44 191 374 7287. Fax: +44 191 3747289. Email: [email protected] Management School, Imperial College, 53 Prince’s Gate, Exhibition Road, London SW7 2PG, United. Tel: +44 207 594 9212. Fax: +44 207 823 7685. Email: [email protected]