A Habit-Based Explanation of the Exchange Rate Risk Premium



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    • Verdelhan is from MIT Sloan School of Management, NBER, and Bank of France. I am highly indebted to John Cochrane, Lars Hansen, Anil Kashyap, and Hanno Lustig, all of whom provided continuous help and support. I also received helpful comments from the editor (Campbell Harvey), an anonymous referee, Kimberly Arkin, David Backus, Ricardo Caballero, John Campbell, Charles Engel, François Gourio, Augustin Landier, Richard Lyons, Julien Matheron, Monika Piazzesi, Raman Uppal, Eric van Wincoop, and seminar participants at various institutions and conferences. All errors are mine.


This paper presents a model that reproduces the uncovered interest rate parity puzzle. Investors have preferences with external habits. Countercyclical risk premia and procyclical real interest rates arise endogenously. During bad times at home, when domestic consumption is close to the habit level, the representative investor is very risk averse. When the domestic investor is more risk averse than her foreign counterpart, the exchange rate is closely tied to domestic consumption growth shocks. The domestic investor therefore expects a positive currency excess return. Because interest rates are low in bad times, expected currency excess returns increase with interest rate differentials.