[Vol.29 No.1] The Korea-U.S. Interest Rate Differential, Real Exchange Rates & the Dollar-Carry Currency Return on the Korean Won: A Present Value Approach

Research Planning & Coordination Team(82-2-759-5490)

Author: Jaeho Yun (Ewha Womans University)

 Using Dahlquist and Pénasse's (2022) present value approach, this paper examines the predictive power of the Korea-U.S. interest rate differential and real exchange rate for the dollar-carry currency return on the Korean won (KRW). For comparison purposes, the currency portfolio of seven developed countries (G7 average) is also analyzed. First, the variance decomposition of the dollar-carry returns on the KRW and G7 average shows that the risk premium shock has a higher contribution than the interest rate differential shock. Second, the KRW temporarily devalues when the interest rate differential between Korea and the U.S. widens, but then gradually appreciates. Third, the predictive ability of the current level of real exchange rate for the future exchange rate is relatively higher than that of the G7 average.

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