Breaking Parity: Equilibrium Exchange Rates and Currency Premia

IMF Working Papers, August 1, 2025

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The paper offers a unifying empirical model of covered and uncovered currency premia, interest rates, and spot and forward exchange rates, both in the cross section and time series of currencies.
Empirical patterns align with a partial equilibrium model of the currency market where hedged and unhedged currency is supplied by intermediary banks subject to value-at-risk balance-sheet constraints.
Emphasis on the frictional nature of equilibrium currency premia and exchange rate dynamics.

Excess supply of local-currency savings is the key determinant of:
- low relative interest rates,
- negative covered and uncovered currency premia,
- cheap forward dollars.
Conversely, the reverse conditions (excess demand for local-currency savings) imply high relative interest rates, positive premia, and expensive forward dollars.

Covered currency premia:
- change infrequently,
- move in concert across currencies,
- are driven by aggregate financial market conditions.
Uncovered currency premia:
- move frequently,
- respond to currency-specific demand shocks,
- are captured by the dynamics of net currency futures positions of dealer banks.
Sharp exchange rate depreciations in response to negative shifts in currency demand are followed by small persistent predictable appreciations that generate future positive expected currency returns necessary to ensure intermediation of currency demand shocks, irrespective of their financial or macroeconomic origin.

Hedged and unhedged currencies are supplied by intermediary banks that face value-at-risk balance-sheet constraints.
These intermediation frictions are central to explaining equilibrium currency premia and exchange rate dynamics.

Changes in net futures positions of dealer banks account for most of the variation in the spot exchange rate for every currency.
Net futures positions capture currency-specific demand shocks that feed into frequent movements in uncovered currency premia.

Breaking Parity: Equilibrium Exchange Rates and Currency Premia, Mai Dao, Pierre-Olivier Gourinchas, Oleg Itskhoki, August 1, 2025.