Pricing the Currency Premium under Flexible Exchange Rates: Evidence from South Africa

Abstract

The currency premium is one of the three components of the differential between local and foreign interest rates. Emerging economies such as South Africa typically face positive interest rate differentials, i.e., a higher cost of capital than developed economies. In this paper we aim at identifying the determinants of the South African rand-U.S. dollar currency premium. Using monthly data over the period 19972008, we carry out an empirical analysis of the determinants of the 1-month and 1-year currency premium. We find that the currency premium at both horizons are driven by long-run movements in the expected inflation differential between South Africa and the U.S., risk aversion as a proxy for the price of rand exchange risk, and the volatility of the rand exchange rate as an indicator of the quantity of that risk. Misalignments in the real effective or rand-U.S. dollar bilateral exchange rates display mixed results in terms of their impact and statistical significance on both currency premium. Our parameter estimators overall are stable and robust to sample variations.

JEL classification: F31 ; F34 ; G12 ; G15