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Exchange Rate Predictability, Risk Premiums, and Predictive System

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  • Yuhyeon Bak

    (Department of Economics, Korea University, 145 Anamro, Seongbuk-gu, Seoul, Korea 02841)

  • Cheolbeom Park

    (Department of Economics, Korea University, 145 Anamro, Seongbukgu, Seoul, Korea 02841)

Abstract

Uncovered interest rate parity is known to perform poorly in forecasting exchange rate movements, especially in the short run. One possible reason for this failure is the existence of unobservable risk premium. We estimate the unobservable risk premium with a predictive system using the implied volatility of at-the-money currency options as an imperfect predictor. We find that expected exchange rate changes, constructed from forward-spot differentials and estimated risk premiums, track actual exchange rate changes more closely than do the fitted values of the Fama regression. When we add the estimated risk premium from the predictive system in the Fama regression, the UIP puzzle becomes weakened. An out-of-sample analysis reveals that adding the estimated risk premium greatly improves the short-run predictability of exchange rates.

Suggested Citation

  • Yuhyeon Bak & Cheolbeom Park, 2020. "Exchange Rate Predictability, Risk Premiums, and Predictive System," Discussion Paper Series 2006, Institute of Economic Research, Korea University.
  • Handle: RePEc:iek:wpaper:2006
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    More about this item

    Keywords

    exchange rate; Bayesian approach; predictive system; risk premium;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F47 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Forecasting and Simulation: Models and Applications

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