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Properties of foreign exchange risk premiums

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  • Sarno, Lucio
  • Schneider, Paul
  • Wagner, Christian

Abstract

We study the properties of foreign exchange risk premiums that can explain the forward bias puzzle, defined as the tendency of high-interest rate currencies to appreciate rather than depreciate. These risk premiums arise endogenously from the no-arbitrage condition relating the term structure of interest rates and exchange rates. Estimating affine (multi-currency) term structure models reveals a noticeable tradeoff between matching depreciation rates and accuracy in pricing bonds. Risk premiums implied by our global affine model generate unbiased predictions for currency excess returns and are closely related to global risk aversion, the business cycle, and traditional exchange rate fundamentals.

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  • Sarno, Lucio & Schneider, Paul & Wagner, Christian, 2012. "Properties of foreign exchange risk premiums," Journal of Financial Economics, Elsevier, vol. 105(2), pages 279-310.
    • Handle: RePEc:eee:jfinec:v:105:y:2012:i:2:p:279-310
    DOI: 10.1016/j.jfineco.2012.01.005
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    More about this item

    Keywords

    Term structure; Exchange rates; Forward bias; Predictability;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)

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