The Missing Risk Premium in Exchange Rates
62 Pages Posted: 14 Dec 2016 Last revised: 29 Nov 2017
Date Written: May 31, 2017
It is well known that the interest rate differential (the forward premium) predicts currency returns. However, we find that the real exchange rate, not the interest rate differential, is the main predictor of currency returns at longer horizons. We relate this finding to other puzzling features of currency markets, namely that the real exchange rate contemporaneously appreciates with the interest rate differential and that the positive relationship between currency risk premia and the interest rate differential reverses over longer horizons. Models in which the currency risk premium depends on the interest rate differential and a missing risk premium, capturing deviations from the purchasing power parity, can rationalize these observations.
Keywords: Currency returns, forward premium puzzle, present-value model, real exchange rates, uncovered interest rate parity.
JEL Classification: E43, F31, G15
Suggested Citation: Suggested Citation