Properties of foreign exchange risk premiums |
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| Authors: | Lucio Sarno Paul Schneider Christian Wagner |
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| Institution: | 1. Cass Business School, City University, London;2. Centre for Economic Policy Research (CEPR), UK;3. Finance Group, Warwick Business School, University of Warwick, Coventry CV4 7AL, UK;4. Institute for Finance, Banking and Insurance, Vienna University of Economics and Business, 1190 Vienna, Austria |
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| 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. |
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| Keywords: | Term structure Exchange rates Forward bias Predictability |
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