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Exchange Rates, Interest Rates, and the Risk Premium

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  • Charles Engel

Abstract

The well-known uncovered interest parity puzzle arises from the empirical regularity that, among developed country pairs, the high interest rate country tends to have high expected returns on its short term assets. At the same time, another strand of the literature has documented that high real interest rate countries tend to have currencies that are strong in real terms - indeed, stronger than can be accounted for by the path of expected real interest differentials under uncovered interest parity. These two strands - one concerning short-run expected changes and the other concerning the level of the real exchange rate - have apparently contradictory implications for the relationship of the foreign exchange risk premium and interest-rate differentials. This paper documents the puzzle, and shows that existing models appear unable to account for both empirical findings. The features of a model that might reconcile the findings are discussed.

Suggested Citation

  • Charles Engel, 2015. "Exchange Rates, Interest Rates, and the Risk Premium," NBER Working Papers 21042, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:21042
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    Cited by:

    1. Pippenger, John, 2017. "Forward Bias, The Failure Of Uncovered Interest Parity And Related Puzzles," University of California at Santa Barbara, Economics Working Paper Series qt2ff194s2, Department of Economics, UC Santa Barbara.
    2. repec:bis:bisbps:95 is not listed on IDEAS
    3. Özmen, M. Utku & Yılmaz, Erdal, 2017. "Co-movement of exchange rates with interest rate differential, risk premium and FED policy in “fragile economies”," Emerging Markets Review, Elsevier, vol. 33(C), pages 173-188.
    4. Sarita Bunsupha, 2018. "Extrapolative Beliefs and Exchange Rate Markets," PIER Discussion Papers 84, Puey Ungphakorn Institute for Economic Research, revised Apr 2018.
    5. Jung, Kuk Mo & Lee, Seungduck, 2015. "A Liquidity-Based Resolution of the Uncovered Interest Parity Puzzle," MPRA Paper 64164, University Library of Munich, Germany.
    6. repec:beo:journl:v:62:y:2018:i:216:p:35-62 is not listed on IDEAS
    7. Christian Mueller-Kademann, 2016. "The puzzle that just isn't," Papers 1604.08895, arXiv.org.
    8. Mikhail Chernov & Drew D. Creal, 2018. "Multihorizon Currency Returns and Purchasing Power Parity," NBER Working Papers 24563, National Bureau of Economic Research, Inc.
    9. Kerstin Bernoth & Jürgen von Hagen & Casper G. de Vries, 2018. "Estimating a Latent Risk Premium in Exchange Rate Futures," Discussion Papers of DIW Berlin 1733, DIW Berlin, German Institute for Economic Research.
    10. repec:bla:jecsur:v:32:y:2018:i:2:p:302-334 is not listed on IDEAS
    11. repec:beo:journl:v:63:y:2018:i:216:p:35-62 is not listed on IDEAS
    12. Stijn Claessens & M. Ayhan Kose, 2017. "Asset prices and macroeconomic outcomes: A survey," CAMA Working Papers 2017-76, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
    13. Berg, Kimberly A. & Mark, Nelson C., 2018. "Global macro risks in currency excess returns," Journal of Empirical Finance, Elsevier, vol. 45(C), pages 300-315.
    14. repec:eee:inecon:v:112:y:2018:i:c:p:167-181 is not listed on IDEAS
    15. repec:wsi:qjfxxx:v:07:y:2017:i:04:n:s2010139217500100 is not listed on IDEAS
    16. Jordi Galí, 2018. "Forward Guidance and the Exchange Rate," Working Papers 1021, Barcelona Graduate School of Economics.
    17. Jordi Galí, 2017. "Forward guidance and the exchange rate," Economics Working Papers 1600, Department of Economics and Business, Universitat Pompeu Fabra, revised Feb 2018.
    18. repec:eee:dyncon:v:90:y:2018:i:c:p:343-365 is not listed on IDEAS
    19. Anella Munro, 2016. "Bond premia, monetary policy and exchange rate dynamics," Reserve Bank of New Zealand Discussion Paper Series DP2016/11, Reserve Bank of New Zealand.
    20. Habimana, Olivier, 2017. "The multiscale relationship between exchange rates and fundamentals differentials: Empirical evidence from Scandinavia," MPRA Paper 75956, University Library of Munich, Germany.

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    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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