Properties of Foreign Exchange Risk Premiums

Lucio Sarno, Paul Schneider, Christian Wagner

Research output: Contribution to journalJournal articleResearchpeer-review

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.

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.

LanguageEnglish
JournalJournal of Financial Economics
Volume105
Issue number2
Pages279–310
ISSN0304-405X
DOIs
StatePublished - Aug 2012

Keywords

    Cite this

    Sarno, Lucio ; Schneider, Paul ; Wagner, Christian. / Properties of Foreign Exchange Risk Premiums. In: Journal of Financial Economics. 2012 ; Vol. 105, No. 2. pp. 279–310
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    Properties of Foreign Exchange Risk Premiums. / Sarno, Lucio ; Schneider, Paul ; Wagner, Christian.

    In: Journal of Financial Economics, Vol. 105, No. 2, 08.2012, p. 279–310.

    Research output: Contribution to journalJournal articleResearchpeer-review

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    AU - Wagner,Christian

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    AB - 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.

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    KW - Exchange rates

    KW - Forward bias

    KW - Predictability

    U2 - 10.1016/j.jfineco.2012.01.005

    DO - 10.1016/j.jfineco.2012.01.005

    M3 - Journal article

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    JO - Journal of Financial Economics

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