Properties of Foreign Exchange Risk Premiums
86 Pages Posted: 24 Aug 2009 Last revised: 27 Apr 2016
Date Written: July 11, 2011
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: Suggested Citation