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Properties of Foreign Exchange Risk PremiumsLucio SarnoCity University London - Sir John Cass Business School; Centre for Economic Policy Research (CEPR) Paul SchneiderUniversity of Lugano - Institute of Finance Christian WagnerCopenhagen Business School July 11, 2011 Journal of Financial Economics (JFE), Forthcoming 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.
Number of Pages in PDF File: 86 Keywords: term structure, exchange rates, forward bias, predictability JEL Classification: F31, E43, G10 Accepted Paper SeriesDate posted: August 24, 2009 ; Last revised: July 13, 2011Suggested CitationContact Information
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