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Handbook of Exchange Rates by Lucio Sarno, Ian Marsh, Jessica James

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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 st 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 images, where rt and images denote the home and foreign one-period nominal interest rates, respectively. We define the FX risk premium, δt, as the expected log excess return, images where images denotes expectations conditioned on period-t information, Ωt. For the present, all we shall assume is that Ωt contains the period-t spot rate and interest rates: st, rt, and .

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

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