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Properties of Foreign Exchange Risk Premiums

Author

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  • Lucio Sarno

    (Faculty of Finance, Cass Business School, City University London, UK; Centre for Economic Policy Research (CEPR), UK; The Rimini Centre for Economic Analysis (RCEA), Italy)

  • Paul Schneider

    (Finance Group, Warwick Business School, University of Warwick, UK)

  • Christian Wagner

    (Institute for Finance, Banking and Insurance, Vienna University of Economics and Business, Austria)

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.

Suggested Citation

  • Lucio Sarno & Paul Schneider & Christian Wagner, 2012. "Properties of Foreign Exchange Risk Premiums," Working Paper series 10_12, Rimini Centre for Economic Analysis.
    • Handle: RePEc:rim:rimwps:10_12
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    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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