A Quantity-Driven Theory of Term Premiums and Exchange Rates
We develop a model in which risk-averse, specialized bond investors must be paid to 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, our model naturally links the predictability of long-term bond returns to the predictability of foreign exchange returns. Specifically, a shift in the net supply of long-term bonds in one currency influences bond term premiums in both currencies as well as the foreign exchange rate between the two currencies. Our model matches several important empirical patterns, including the co-movement between exchange rates and bond term premiums as well as the finding that central banks' quantitative easing policies impact not only local-currency long-term yields, but also foreign exchange rates. We also show that this quantity-driven approach provides a unified account explaining both why foreign exchange tends to outperform when the foreign interest rates exceed domestic rates and why long-term bonds tend to outperform when the yield curve is steep.
Keywords: term premium; exchange rate; Bonds; Currency; Theory;
Citation:
Greenwood, Robin, Samuel G. Hanson, Jeremy C. Stein, and Adi Sunderam. "A Quantity-Driven Theory of Term Premiums and Exchange Rates." Working Paper, November 2019. View Details