Pricing Currency Risk: Facts and Puzzles from Currency Boards

Abstract

Schmukler and Serven investigate the patterns and determinants of the currency risk premium in two currency boards - Argentina and Hong Kong. Despite the presumed rigidity of currency boards, currency premium is almost always positive and at times very large. Its term structure is usually upward sloping, but flattens out or even becomes inverted at times of turbulence. Currency premia differ across markets. The forward discount typically exceeds the currency premium derived from interbank rates, particularly during times of crisis. The large magnitude of these cross-market differences can be the consequence of unexploited arbitrage opportunities, market segmentation, or other risks embedded in typical measures of currency risk. The premium and its term structure depend on domestic and global factors related to devaluation expectations and risk perceptions.

This paper - a product of the Macroeconomics and Growth, Development Research Group - is part of a larger effort in the group to understand how capital market and exchange rate regimes work.

Keywords: currency risk, currency premium, forward discount, currency board, term structure, covered interest parity, market segmentation, financial crises

JEL Classification: F31, F36, G12, G15