Determinants of Currency Risk Premiums

42 Pages Posted: 11 Aug 1999

See all articles by John A. Carlson

John A. Carlson

Purdue University - Department of Economics

Carol L. Osler

Brandeis University - International Business School

Date Written: February 1999

Abstract

This paper presents a theoretical model of exchange-rate determination intended to address the forward premium puzzle. It also explains the empirical observation that risk premiums depend on interest differentials. The model's closed-form solution indicates that currency risk premiums depend on two factors: interest differentials and the current deviation of the exchange rate from its long-run equilibrium. If speculators have an alternative to exchange-rate speculation, then there is no presumption that uncovered interest parity holds even approximately in long-run equilibrium. The model is consistent with existing evidence suggesting that forward premiums are negatively related to rationally expected future exchange rate changes. New empirical evidence is provided in support of the model.

JEL Classification: F31, F47

Suggested Citation

Carlson, John A. and Osler, Carol L., Determinants of Currency Risk Premiums (February 1999). FRB of New York Staff Report No. 70. Available at SSRN: https://ssrn.com/abstract=163175 or http://dx.doi.org/10.2139/ssrn.163175

John A. Carlson

Purdue University - Department of Economics ( email )

Krannert School of Management
West Lafayette, IN 47907-1310
United States

Carol L. Osler (Contact Author)

Brandeis University - International Business School ( email )

Mailstop 32
Waltham, MA 02454-9110
United States
781-736-4826 (Phone)

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