...[H]alf of a given rise in the risk premium is reflected in a rise in the inflation indexed bond return differentials.
In Hot Tip: Nominal Exchange Rates and Inflation Indexed Bond Yields (NBER Working Paper No. 18726), Richard Clarida derives a structural relationship between the nominal exchange rate, national price levels, and observed yields on long maturity inflation-indexed bonds. Then, using high frequency data spanning the period January 2001 to February 2011, he decomposes the pound, euro, and yen exchange rates against the dollar into their fair value and risk premium components.
This methodology identifies the importance of shocks to fair value and shocks to risk premium in explaining exchange rate fluctuations over different periods, as well as over various horizons of interest. For example, Clarida shows that the rapid change in the euro-dollar exchange rate from 1.45 in the spring of 2008 to 1.60 in the summer of 2008 was almost entirely attributable to a rise in the risk premium in favor of the dollar, and thus against the euro. In fact, since the onset of the global financial crisis in September 2008, movements in the euro have been dominated by fluctuations in the risk premium, while the fair value has fluctuated in a narrow range around 1.37. Similarly, movements in the fair value of the pound have been restricted to a narrow range around 1.65. In contrast, movements in the Japanese yen between 2005 and 2010 are almost fully accounted for by a shift in the fair value, while the fluctuations in the risk premium during that period were small and not very volatile.
Overall, Clarida finds that the relative importance of the two factors - fair value and risk premium - varies depending on the sub-sample studied. On average, for all three exchange rates, roughly half of a given rise in the risk premium is reflected in a rise in the inflation-indexed bond return differentials in favor of the foreign country, and the remaining half is reflected in an appreciation of the dollar