A Preferred-Habitat Model of Term Premia, Exchange Rates, and Monetary Policy Spillovers

Publication Date
Financial Markets Group Discussion Papers DP 869
Publication Date
Paul Woolley Centre Discussion Papers No 93
Publication Authors

We develop a two-country model in which currency and bond markets are populated by different investor clienteles, and segmentation is partly overcome by arbitrageurs with limited capital. Risk premia in our model are time-varying, connected across markets, and consistent with the empirical violations of Uncovered Interest Parity and Expectations Hypothesis. Through risk premia, large-scale bond purchases lower domestic and foreign bond yields and depreciate the currency, and short-rate cuts lower foreign yields, with smaller effects than bond purchases. Currency returns are disconnected from long-maturity bond returns, and yet the currency market is instrumental in transmitting bond demand shocks across countries.


This is a revised version of May 2024. The previous version was dated March 2022.