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Properties of Foreign Exchange Risk Premia

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

Abstract

We study the properties of foreign exchange risk premia that can explain the forward bias puzzle - the tendency of high-interest rate currencies to appreciate rather than depreciate. These risk premia arise endogenously from imposing the no-arbitrage condition on the relation between the term structure of interest rates and exchange rates, and they compensate for both currency risk and interest rate risk. In our empirical analysis, we estimate risk premia using an affine multi-currency term structure model and find that model-implied risk premia yield unbiased predictions for exchange rate excess returns. While interest rate risk affects the level of risk premia, the time-variation in excess returns is almost entirely driven by currency risk. Furthermore, risk premia are (i) closely related to global risk aversion, (ii) countercyclical to the state of the economy, and (iii) tightly linked to traditional exchange rate fundamentals.

Suggested Citation

  • Sarno, Lucio & Schneider, Paul & Wagner, Christian, 2010. "Properties of Foreign Exchange Risk Premia," MPRA Paper 21302, University Library of Munich, Germany.
    • Handle: RePEc:pra:mprapa:21302
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    Cited by:

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    2. Menkhoff, Lukas & Sarno, Lucio & Schmeling, Maik & Schrimpf, Andreas, 2012. "Currency momentum strategies," Journal of Financial Economics, Elsevier, vol. 106(3), pages 660-684.
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    4. Lasha Kavtaradze & Manouchehr Mokhtari, 2018. "Factor Models And Time†Varying Parameter Framework For Forecasting Exchange Rates And Inflation: A Survey," Journal of Economic Surveys, Wiley Blackwell, vol. 32(2), pages 302-334, April.

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    More about this item

    Keywords

    term structure; exchange rates; forward bias; predictability;
    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
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)

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