The Missing Risk Premium in Exchange Rates

62 Pages Posted: 14 Dec 2016 Last revised: 29 Nov 2017

Magnus Dahlquist

Stockholm School of Economics; Swedish House of Finance

Julien Penasse

University of Luxembourg

Date Written: May 31, 2017

Abstract

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

Dahlquist, Magnus and Penasse, Julien, The Missing Risk Premium in Exchange Rates (May 31, 2017). 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 Penasse (Contact Author)

University of Luxembourg ( email )

4 Rue Albert Borschette
Luxembourg, L-1246
Luxembourg

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