The two models in the monetary approach and Dornbusch overshooting assume domestic and foreign bonds are perfect substitutes, so a single interest-parity condition ties them together. Drop that and you get the portfolio-balance approach, in which investors hold three assets (domestic money, domestic bonds and foreign bonds) and demand compensation for concentrating in any one of them.
Currency risk premium formula
The parity condition acquires a third term:
i_domestic − i_foreign = E[%ΔS] + risk premium
That term is doing real work. Take the inputs in the five parity conditions: the rupee pays 240 basis points over the dollar, and suppose a survey of forecasters puts expected rupee depreciation at only 1.20%. Solving exactly rather than by subtraction:
(1 + 0.0675) / [(1 + 0.0435) × (1 + 0.0120)] − 1 = 1.086909%
so the market is paying about 109 basis points to hold rupee assets over and above the expected currency loss. The crude subtraction, 2.40 − 1.20 = 1.20 percentage points, overstates that by 0.113091 points, which is 11 basis points of a 109-basis-point quantity, an error of a tenth.
Where does the premium come from? From the relative supply of assets. If a government runs persistent deficits, the stock of its bonds grows relative to everything else, and investors who must hold a larger share of their portfolio in one country's paper demand more to do it. That is the channel by which fiscal policy reaches the currency under a floating rate, and it operates on stocks rather than flows, so it works slowly and then suddenly.
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Worked example: rising public debt
Put numbers on it. Suppose public debt rises from 58% of GDP to 74%, and suppose the market charges 35 basis points of extra currency risk premium for every 10 percentage points of debt-to-GDP. The premium rises 56 basis points, from 1.086909% to 1.646909%. Hold the interest rates fixed and hold the market's view of the level of the rupee in a year fixed at ₹85.514000. Then the expected depreciation from today must fall to 0.642462%, and the only way that happens with the endpoint fixed is for the spot to jump weaker now:
S_today = 85.514000 / 1.00642462 = ₹84.968112
an immediate depreciation of 0.553979%, or 46.81 paise. The currency moved because the required return moved, with no change in interest rates, no change in inflation and no change in the trade balance.
Can a floating currency ignore the fiscal position?
That mechanism is the honest answer to a question analysts get asked constantly, which is whether a country with its own floating currency can ignore its fiscal position. It cannot. It can decline to default, which is a real and important privilege, and it pays for that privilege in the currency and eventually in the inflation rate.
A floating rate changes the form the discipline takes. It does not remove it.
The stated 35-basis-point sensitivity is an assumption, and it is the weakest number in the whole portfolio-balance argument. Published estimates of how much a currency risk premium moves with the debt stock vary by an order of magnitude across samples, periods and country groups. Treat the arithmetic as a way of asking "how big would the sensitivity have to be for this to matter?" rather than as a calibration.