Intertemporal Substitution, Precautionary Saving, and the Currency Risk Premia

There are two seemingly contradictory empirical regularities in international finance: the high interest rate currency tends to have higher currency risk premia in short horizons but lower currency risk premia in long horizons. Engel (2016) shows that existing models cannot accommodate these two puzzles simultaneously and terms them a paradox. In this paper, we provide a rational resolution to Engel's paradox. Our deviation from existing models is the following two assumptions on consumption processes: (i) the expected future consumption variance have more than one decay modes and (ii) the mean consumption growth depends on the slowest decay mode. Market friction, recursive utility and bounded rationality are not assumed. Calibration exercises confirm key implications of our model