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The missing risk premium in exchange rates

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  • Dahlquist, Magnus
  • Pénasse, Julien

Abstract

We use a present-value model of the real exchange rate to impose structure on the currency risk premium. We allow the currency risk premium to depend on both the interest rate differential and a latent component: the missing risk premium. Consistent with the data, our present-value model implies that the real exchange rate should predict currency returns. We find that the missing risk premium, not the interest rate differential, explains most of the variation in the real exchange rate. Moreover, our model sheds light on puzzling relations between the interest rate differential, the real exchange rate, and the currency risk premium.

Suggested Citation

  • Dahlquist, Magnus & Pénasse, Julien, 2022. "The missing risk premium in exchange rates," Journal of Financial Economics, Elsevier, vol. 143(2), pages 697-715.
    • Handle: RePEc:eee:jfinec:v:143:y:2022:i:2:p:697-715
    DOI: 10.1016/j.jfineco.2021.07.001
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    6. Bruno Feunou & Jean-Sébastien Fontaine & Ingomar Krohn, 2022. "Real Exchange Rate Decompositions," Discussion Papers 2022-6, Bank of Canada.
    7. Mikhail Chernov & Magnus Dahlquist & Lars Lochstoer, 2023. "Pricing Currency Risks," Journal of Finance, American Finance Association, vol. 78(2), pages 693-730, April.
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    9. Mo, Wan-Shin & Yang, J. Jimmy & Chen, Yu-Lun, 2023. "Exchange rate spillover, carry trades, and the COVID-19 pandemic," Economic Modelling, Elsevier, vol. 121(C).

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    More about this item

    Keywords

    Currency return; Forward premium puzzle; Purchasing power parity; State-space model; Uncovered interest rate parity;
    All these keywords.

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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