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Properties of Foreign Exchange Risk Premiums

  • 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)

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.

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Paper provided by The Rimini Centre for Economic Analysis in its series Working Paper Series with number 10_12.

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Date of creation: Mar 2012
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Publication status: Forthcoming in the Journal of Financial Economics
Handle: RePEc:rim:rimwps:10_12
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