Are Risk Premia Related to Real Exchange Rate Swings? Survey Expectations and I(2) Trends

This paper tests the ex ante implications of Frydman and Goldberg's Imperfect Knowledge Economics (IKE) gap model in such a way as to overcome the endogeneity bias and data restrictions of previous work. The IKE gap model relates the expected excess return (measured here through survey data for three exchange rates) to the deviation or "gap" between the exchange rate and its benchmark value, proxied with Purchasing Power Parity. Strong support is found for this hypothesis in a Polynomially (I(2)) Cointegrated VAR analysis. This statistical framework more adequately addresses non-stationarity and provides a better examination of the driving and adjustment dynamics. Evidence of persistent changes, or near I(2) behavior, is found for several variables including relative interest rates and prices, as well as for the real exchange rate in some instances, which is contrary to REH theory but consistent with the IKE theory.