Discussion Paper Details

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Title: Properties of Foreign Exchange Risk Premiums

Author(s): Lucio Sarno, Paul Schneider and Christian Wagner

Publication Date: August 2011

Keyword(s): exchange rates, forward bias, predictability and term structure

Programme Area(s): Financial Economics and International Macroeconomics

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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Bibliographic Reference

Sarno, L, Schneider, P and Wagner, C. 2011. 'Properties of Foreign Exchange Risk Premiums'. London, Centre for Economic Policy Research.