Abstract
This paper is motivated by two facts: failure of log-linear empirical exchange rate models of the 1970's and the observed variability of risk premiums in the forward market. Rational maximizing models predict that changes in conditional variances of monetary policies, government spendings, and income growths affect risk premiums and induce conditional volatility of exchange rates. I examine theoretically how changes in these exogenous conditional variances affect the level of the current exchange rate and attempt to quantify the extent that this channel explains exchange rate volatility using autoregressive conditional heteroscedastic models.
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