Incomplete Consumption Risk Sharing and Currency Risk Premiums

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Abstract
This article studies the impact of imperfect consumption risk sharing across countries on the formation of time-varying risk premiums in the foreign exchange market and on their cross-sectional differences. These issues are addressed within the framework of the Constantinides and Duffie (1996) model applied to a multicountry world. The article shows that the cross-country variance of consumption growth rates is counter-cyclical and that this feature of consumption data is mildly helpful for currency pricing. In particular, unlike the standard CCAPM, the new model is able to generate currency risk premiums at lower values of risk aversion and provide certain explanatory power for cross-sectional differences in currency returns.