Properties of Foreign Exchange Risk Premiums
Author(s): Lucio Sarno, Paul Schneider, Christian Wagner
CEPR Discussion Paper Number 8503
Paper Details | PDF Download* | Purchase Electronic | Purchase Printed
Programme Area(s): Financial Economics (FE), International Macroeconomics (IM)
Date of Publication: 01/08/2011
Keyword(s): exchange rates, forward bias, predictability, term structure
JEL(s): E43, F31, G10
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.
* CEPR Research Fellows and Affiliates, Corporate Members and Subscribers can download papers without charge. Individual Papers may be purchased at www.cepr.org
Author(s): Lucio Sarno, Paul Schneider, Christian Wagner
CEPR Discussion Paper Number 8503
Paper Details | PDF Download* | Purchase Electronic | Purchase Printed
Programme Area(s): Financial Economics (FE), International Macroeconomics (IM)
Date of Publication: 01/08/2011
Keyword(s): exchange rates, forward bias, predictability, term structure
JEL(s): E43, F31, G10
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.
* CEPR Research Fellows and Affiliates, Corporate Members and Subscribers can download papers without charge. Individual Papers may be purchased at www.cepr.org