Breaking Parity: Equilibrium Exchange Rates and Currency Premia

We offer a unifying empirical model of covered and uncovered currency premia, interest rates and spot and forward exchange rates, both in the cross section and time series of currencies. We find that the rich empirical patterns are in line with a partial equilibrium model of the currency market, where hedged and unhedged currency is supplied by intermediary banks subject to value-at-risk balance-sheet constraints, emphasizing the frictional nature of equilibrium currency premia and exchange rate dynamics. In the cross section, the excess supply of local-currency savings is the key determinant of low relative interest rates, negative covered and uncovered currency premia, cheap forward dollars; and vice versa. In the time series, covered currency premia change infrequently and in concert across currencies, driven by aggregate financial market conditions. In contrast, uncovered currency premia move frequently in response to currency-specific demand shocks, which we capture with the dynamics of net currency futures positions of dealer banks. Sharp exchange rate depreciations in response to negative shifts in currency demand are followed by small persistent predictable appreciations that generate future positive expected currency returns necessary to ensure intermediation of currency demand shocks, irrespective of their financial or macroeconomic origin. Changes in net futures positions of dealer banks account for most of the variation in the spot exchange rate for every currency.