Journal of Financial Economics Vol. 105 No. 2 2012

Properties of foreign exchange risk premiums

Lucio Sarno^1,2; Paul Schneider^3,4,5; Christian Wagner⁶

¹ Centre for Economic Policy Research · ² City, University of London · ³ Università della Svizzera italiana · ⁴ Swiss Finance Institute · ⁵ University of Warwick · ⁶ Vienna University of Economics and Business

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.

DOI

10.1016/j.jfineco.2012.01.005

Volume

105

Issue

2

Pages

279-310

Language

en

Sources

bibtex:phds-export.bib openalex crossref

Cite

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