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Intermediate Microeconomics, autumn 2018

The three essays involve the spot, forward and option markets for foreign exchange rates respectively. The first essay develops a very general, although partial equilibrium microeconomic model with multiple assets, goods, currencies, and tax rates in stochastic continuous time, and uses it to test for these possible sources of heterogeneity in the international pricing of risky capital assets with inflation and exchange rate risks. Applying various econometric procedures including MLE with nonnormal disturbances, it is found that national constraints on investment opportunity sets rather than national differences in attitudes toward risk or in consumption preferences account for heterogeneity in asset pricing.^ The second essay examines the factors underlying variations in risk premia and in market forecast errors in forward exchange markets. Accounting for strong non-normality in the data, it is shown that we cannot be unequivocal about whether variations are stronger in risk premia or in market forecast errors. Then, optimal portfolios of currency forward contracts, formed under realistic market conditions, are found to generate favorable average out-of-sample risk-return profiles over the entire post Bretton Woods period. Finally, the property of high signal-to-noise ratio in this optimal portfolio returns series is utilized to demonstrate that variations in both risk premia and market forecast errors are driven by fluctuations in such macroeconomic variables as differential production, interest and inflation rates, and money supplies than financial market indices.