Properties of Foreign Exchange Risk Premiums

Lucio Sarno, Paul Schneider, Christian Wagner

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    Abstract

    We study the properties of foreign exchange risk premiums that can explain the forward bias puzzle, defined as the tendency of high-interest rate currencies to appreciate rather than depreciate. These risk premiums arise endogenously from the no-arbitrage condition relating the term structure of interest rates and exchange rates. Estimating affine (multi-currency) term structure models reveals a noticeable tradeoff between matching depreciation rates and accuracy in pricing bonds. Risk premiums implied by our global affine model generate unbiased predictions for currency excess returns and are closely related to global risk aversion, the business cycle, and traditional exchange rate fundamentals.
    Original languageEnglish
    JournalJournal of Financial Economics
    Volume105
    Issue number2
    Pages (from-to)279–310
    Number of pages32
    ISSN0304-405X
    DOIs
    Publication statusPublished - Aug 2012

    Keywords

    • Term structure
    • Exchange rates
    • Forward bias
    • Predictability

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