- Exchange rate risk and business cycles
Bank of England
We show that currencies with a steeper yield curve tend to depreciate at business cycle horizons, in violation of uncovered interest parity. The yield curve adds no explanatory power over and above spot yield differentials in explaining exchange rates at longer horizons. Analysing bond holding period returns, we identify a tent-shaped relationship between the exchange rate risk premium and the relative slope across horizons. We derive this relationship analytically within an asset pricing framework and show it is driven by differences in transitory innovations to investors’ stochastic discount factor, captured by the relative yield curve slope and consistent with business cycle risk. Our mechanism is robust to the inclusion of liquidity yields, which instead contribute to explaining cross-sectional differences across currencies and reflect permanent innovations to investors’ stochastic discount factor.