Interest Rate Risk and the Forward Premium Anomaly in Foreign Exchange Markets

This paper shows that even adjusted for the time-varying risk premiums implied by the yield curves across countries, uncovered interest parity is still strongly rejected by the data. Moreover, factors that predict the excess bond returns are found not significant at all in predicting the foreign exchange returns. These results reject the joint restrictions on the exchange rate and interest rates imposed by dynamic term-structure models, suggesting that foreign exchange markets and bond markets may not be fully integrated and we have to look beyond interest rate risk in order to understand the exchange rate anomaly.