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New Zealand's currency risk premium

Christian Hawkesby, Christie Smith, Christine Tether

In this article we examine whether New Zealand having its own currency leads to higher interest rates in New Zealand when compared to Australia or the United States. Differences between domestic and foreign interest rates can arise: (1) because the underlying assets are subject to differences in liquidity risk and default risk; (2) because of expected changes in the exchange rate; and (3) because of a ‘currency risk premium’ that might occur on account of uncertainty about the future value of the currency. Given that the currency risk premium is not directly observable, our methodology is to estimate it as a residual, by subtracting estimates of (1) and (2) from the interest rate differentials we observe. We present a variety of different estimates for New Zealand’s currency risk premium using different measures of exchange rate expectations. Our estimates of the currency risk premium depend crucially on the assumptions that are made about expected exchange rate movements. Our analysis suggests that over the 1990s New Zealand has faced a relatively significant currency risk premium versus the United States. There is also some evidence of a currency risk premium in our interest rates versus those of Australia, although this premium seems to be smaller in magnitude. These results suggest that forming a currency area with Australia would have less impact on New Zealand interest rates than would forming a currency area that included the United States. However, before deciding whether such an outcome would be desirable or not, the other costs and benefits involved in adopting a common currency would need to be considered.