A Habit-Based Explanation of the Exchange Rate Risk Premium

This paper presents a model that reproduces the uncovered interest rate parity puzzle, based on a time-varying business-cycle related risk premium. Agents have preferences with external habits. During bad times in the home market, when the domestic habit is close to domestic consumption level, the exchange rate becomes more sensitive to domestic than to foreign aggregate consumption growth shocks. As a result, the foreign currency depreciates in case of a negative consumption growth shock at home. Hence, investing in foreign currency is risky in bad times, when domestic interest rates are low relative to foreign interest rates.