Properties of Foreign Exchange Risk Premiums

86 Pages Posted: 24 Aug 2009 Last revised: 27 Apr 2016

See all articles by Lucio Sarno

Lucio Sarno

University of Cambridge - Judge Business School; Centre for Economic Policy Research (CEPR)

Paul Schneider

University of Lugano - Institute of Finance; Swiss Finance Institute

Christian Wagner

WU Vienna University of Economics and Business; Vienna Graduate School of Finance (VGSF)

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Date Written: July 11, 2011

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.

Keywords: term structure, exchange rates, forward bias, predictability

JEL Classification: F31, E43, G10

Suggested Citation

Sarno, Lucio and Schneider, Paul Georg and Wagner, Christian, Properties of Foreign Exchange Risk Premiums (July 11, 2011). Journal of Financial Economics (JFE), Forthcoming, Available at SSRN: https://ssrn.com/abstract=1460489

Lucio Sarno

University of Cambridge - Judge Business School ( email )

Trumpington Street
Cambridge, CB2 1AG
United Kingdom

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Paul Georg Schneider

University of Lugano - Institute of Finance ( email )

Via Buffi 13
CH-6900 Lugano
Switzerland

Swiss Finance Institute ( email )

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Christian Wagner (Contact Author)

WU Vienna University of Economics and Business ( email )

Welthandelsplatz 1
Vienna, Wien 1020
Austria

Vienna Graduate School of Finance (VGSF) ( email )

Welthandelsplatz 1
Vienna, 1020
Austria

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