Liquidity premia and interest rate parity
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Date
2013-10-29
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Abstract
Risk-free assets denominated in US currency not only offer
a pecuniary return, but also provide transactions services,
both nationally and internationally. Accordingly, the responses of bilateral US dollar exchange rates to interest rate
shocks should differ substantially with respect to the (US or
foreign) origin of the shock. We demonstrate this empirically
and apply a model of liquidity premia on US treasuries originating from monetary policy implementation. The liquidity
premium leads to a modi fication of uncovered interest rate
parity (UIP), which is able to explain observed deviations of
exchange rate dynamics from UIP predictions. In line with
empirical evidence, the model predicts an appreciation of
the US dollar subsequent to an increase in US interest rates
as well as in SOE interest rates.
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Keywords
exchange rate dynamics, liquidity premia, monetary policy shocks, uncovered interest rate parity