Handbook of Exchange Rates

3.2 Perspectives on Spot-Rate Dynamics

We begin by providing a broad perspective on the possible factors that drive spot exchange rates. For this purpose, we first derive a simple decomposition for the period-by-period depreciation rate that must hold in any exchange-rate model; that is, traditional macro models and micro-based models. We then use this decomposition to identify the key differences between micro-based models and their traditional macro counterparts.

3.2.1 Decomposition of Depreciation Rates

We begin with some definitions. Let s_t denote the log spot exchange rate defined as the domestic price of foreign currency. The log excess return on foreign currency between periods t and t + 1 is , where r_t and denote the home and foreign one-period nominal interest rates, respectively. We define the FX risk premium, δ_t, as the expected log excess return, where denotes expectations conditioned on period-t information, Ω_t. For the present, all we shall assume is that Ω_t contains the period-t spot rate and interest rates: s_t, r_t, and .

Our aim is to provide a decomposition for the ...