The Excess Volatility in Foreign Exchange Risk Premium and the Forward Rate Bias
Posted: 16 Apr 2018 Last revised: 25 Mar 2019
Date Written: February 20, 2018
We address the question of the documented excess volatility of the foreign exchange risk premium, relative to the volatility of the interest rate differential, which cannot be explained by the uncovered interest rate parity. By specifying an affine interest rate model, we study the expected future spot rates, forward rates, and the behavior of the risk premium. We find that the discrepancy between the volatility of the risk premium and the volatility of interest-rate differentials is largely explained by the additional risk associated with the uncertainties that result in shifts of the monetary regimes. This obvious but overlooked source of risk, the gray rhino scenario, accounts for much of the excess variation in foreign exchange risk premium. Thus we explain larger volatility in the risk premium than that in the interest rate differential, and verify the conditions of decomposition in the implied forward rate equation.
Keywords: Risk Premium, Forward Bias, Gray Rhino, Term Structure, Global Factor
JEL Classification: E43; F31; G10; G12
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