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U.S. Dollar Dynamics: How Important Are Policy Divergence and FX Risk Premiums?

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  • Mr. Ravi Balakrishnan
  • Stefan Laseen
  • Mr. Andrea Pescatori

Abstract

We investigate the drivers of dynamics of major U.S. FX bilaterals. We first construct a novel measure of FX risk premiums using Consensus exchange rate forecasts. We then use VAR analysis to show that (i) risk premium shocks play a key role in driving dynamics of the major U.S. FX bilaterals; (ii) longer-term interest differentials also matter, especially for the Canadian $ and the Euro; (iii) oil price shocks play a particularly important role for the Canadian $ (an oil exporter); and (iv) risk appetite shocks (e.g., VIX shocks) generally lead to U.S. dollar appreciation. The importance of risk premium and longer-term interest differential shocks fit well with a simple theoretical model and are supported by recent event studies.

Suggested Citation

  • Mr. Ravi Balakrishnan & Stefan Laseen & Mr. Andrea Pescatori, 2016. "U.S. Dollar Dynamics: How Important Are Policy Divergence and FX Risk Premiums?," IMF Working Papers 2016/125, International Monetary Fund.
    • Handle: RePEc:imf:imfwpa:2016/125
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    2. Longaric, Pablo Anaya, 2022. "Foreign currency exposure and the financial channel of exchange rates," Working Paper Series 2739, European Central Bank.
    3. Fatemeh Salimi, 2020. "Exchange Rates, Stock Prices, and Stock Market Uncertainty," Working Papers halshs-03007904, HAL.
    4. Fatemeh Salimi Namin, 2020. "Exchange Rates, Stock Prices, and Stock Market Uncertainty," AMSE Working Papers 2037, Aix-Marseille School of Economics, France.
    5. Mr. Yasser Abdih & Mr. Ravi Balakrishnan & Baoping Shang, 2016. "What is Keeping U.S. Core Inflation Low: Insights from a Bottom-Up Approach," IMF Working Papers 2016/124, International Monetary Fund.

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