Inflation Expectations and Risk Premiums: Implications for Korean Exchange Rates

Nominal yield can be decomposed into real rates, inflation expectations, and inflation risk premia. We estimate an affine term structure model that allows us to decompose nominal bond yields and use the model to study Korea–US exchange rate movements. Our results show that expected inflation and the inflation risk premium have considerable predictive power for Korea–US exchange rates beyond other yield curve factors and macro-variables. In particular, we find that those two nominal factors play a stronger role after 2005. It implies that not only the level of inflation but also inflation uncertainty should be taken into account for predicting Korea–US exchange rates dynamics (JEL classification: E43, F31, G12).