The Missing Risk Premium in Exchange Rates

71 Pages Posted: 14 Dec 2016 Last revised: 14 Apr 2021

See all articles by Magnus Dahlquist

Magnus Dahlquist

Stockholm School of Economics; Swedish House of Finance

Julien Pénasse

University of Luxembourg

Date Written: October 27, 2020

Abstract

We use a present-value model of the real exchange rate to impose structure on the currency risk premium. We allow the currency risk premium to depend on both the interest rate differential and a latent component—the missing risk premium. Consistent with the data, our present-value model implies that the real exchange rate should predict currency returns. We find that the missing risk premium, not the interest rate differential, explains most of the variation in the real exchange rate. Moreover, our model sheds light on puzzling relations between the interest rate differential, the real exchange rate, and the currency risk premium.

Keywords: Currency returns, forward premium puzzle, purchasing power parity, state-space model, uncovered interest rate parity.

JEL Classification: E43, F31, G15

Suggested Citation

Dahlquist, Magnus and Pénasse, Julien, The Missing Risk Premium in Exchange Rates (October 27, 2020). Swedish House of Finance Research Paper No. 17-18, Available at SSRN: https://ssrn.com/abstract=2884890 or http://dx.doi.org/10.2139/ssrn.2884890

Magnus Dahlquist

Stockholm School of Economics ( email )

Drottninggatan 98
Stockholm, SE-111 60
Sweden

Swedish House of Finance ( email )

Drottninggatan 98
111 60 Stockholm
Sweden

Julien Pénasse (Contact Author)

University of Luxembourg ( email )

4 Rue Albert Borschette
Luxembourg, L-1246
Luxembourg

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