Abstract
This dissertation consists of three essays. Essay 1: Common Trends in Prices and Exchange Rates – Tests of Long-Run Purchasing Power Parity. This essay examines the empirical validity of long-run purchasing power parity by means of multivariate cointegration tests due to Johansen (1988, 1991a). The tests are performed not only on bilateral exchange rates, but also on a multilateral basis. The study is performed on monthly data covering almost 22 years (January 1970 – August 1991) for four countries – Germany, Japan, the US., and the Great Britain. While the cointegration analysis does uncover three stationary linear combinations among the set of nominal exchange rates and domestic price levels, or equivalently, finds a reduced number of common stochastic trends, none of these can be explained as long-run PPP relations. We conclude that neither bilateral nor multilateral PPP can be supported by the behavior of the data. Essay 2: Exchange Rate Expectations, the Forward Exchange Rate Bias and Risk Premia in target Zones. A method proposed by Bertola and Svensson (1993) is used to extract expected rates of depreciation within the target zone band for four Nordic currencies 1979 – 1989. These are then combined with time-series of expected rates of devaluation (defined as changes in central parities of the target zones) estimated by Edin och Vredin (1993). The result is time-series of the overall expected change in the exchange rate for the four currencies. Using these we can residually construct time-series of the foreign exchange risk premium and expectational errors. We find substantial and time-varying risk premia, why we question the widely used practice of assuming that the UIP holds, e.g. when studying the credibility of target zone regimes. The estimated time-series of risk premia and expectational errors are used to attribute the forward exchange rate bias to expectational errors and/or risk premia, following a decomposition derived in Froot and Frankel (1989). We conclude that for the four Nordic Countries studied in this essay – Denmark, Finland, Norway and Sweden – time-varying risk premia appear to be the dominant cause of deviations from UIP, while the role of expectational errors is less clear. Essay 3: International Portfolio Diversification and the Foreign Exchange Risk Premium. A multi-country model of intertemporal portfolio choice and the foreign exchange risk premium which incorporates both nominal price and relative price risk is developed. Portfolio demands are derived and interpreted in terms of diversification and hedge portfolios. The equilibrium foreign exchange risk premium is then analyzed and discussed in terms of e.g. relative and nominal price uncertainty. Special attention is paid to the effects of deviations from the purchasing power parity.