A Quantity-Driven Theory of Term Premia and Exchange Rates

56 Pages Posted: 4 Aug 2020 Last revised: 16 Jun 2021

See all articles by Robin M. Greenwood

Robin M. Greenwood

Harvard Business School - Finance Unit; National Bureau of Economic Research (NBER)

Samuel Gregory Hanson

Harvard University - Business School (HBS)

Jeremy C. Stein

Harvard University - Department of Economics; National Bureau of Economic Research (NBER)

Aditya Sunderam

Harvard University

Date Written: July 2020

Abstract

We develop a model in which specialized bond investors must absorb shocks to the supply and demand for long-term bonds in two currencies. Since long-term bonds and foreign exchange are both exposed to unexpected movements in short-term interest rates, a shift in the supply of long-term bonds in one currency influences the foreign exchange rate between the two currencies, as well as bond term premia in both currencies. Our model matches several important empirical patterns, including the co-movement between exchange rates and term premia, as well as the finding that central banks' quantitative easing policies impact exchange rates. An extension of our model sheds light on the persistent deviations from covered interest rate parity that have emerged since 2008.

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Suggested Citation

Greenwood, Robin M. and Hanson, Samuel Gregory and Stein, Jeremy C. and Sunderam, Aditya, A Quantity-Driven Theory of Term Premia and Exchange Rates (July 2020). NBER Working Paper No. w27615, Available at SSRN: https://ssrn.com/abstract=3665886

Robin M. Greenwood (Contact Author)

Harvard Business School - Finance Unit ( email )

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Samuel Gregory Hanson

Harvard University - Business School (HBS) ( email )

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Jeremy C. Stein

Harvard University - Department of Economics ( email )

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National Bureau of Economic Research (NBER)

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Aditya Sunderam

Harvard University ( email )

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