Currency Risk Premium, Interest Rate Differentials, and the Holding Period

47 Pages Posted: 23 Feb 2014 Last revised: 9 Apr 2014

See all articles by Shingo Goto

Shingo Goto

University of Rhode Island - College of Business Administration

Yan Xu

HKU, Faculty of Business and Economics

Yuzhao Zhang

Rutgers, The State University of New Jersey - Department of Finance

Date Written: March 2014

Abstract

Conducting a Beveridge-Nelson decomposition on exchange rates reveals that the prospective interest rate differential -- the expected infinite sum of future interest rate differentials (i.e., the "prospective'') -- can help predict foreign exchange market excess returns. We find that the prospective is even more negatively correlated with excess returns than interest rate differential, implying a more profitable trading strategy and further deepening the forward premium puzzle. Moreover, relative to the U.S. dollar, foreign currencies with higher interest rates, on average, turn from more risky to less risky over cumulative holding periods (i.e., a "level'' effect). However, foreign currencies with higher interest rates remain more risky than foreign currencies with lower interest rates in the cross section (a "slope'' effect). These level and slope effects further deepen the puzzle raised in Engel (2011) and impose more challenges on extant asset pricing models.

Keywords: prospective interest rate differential, currency risk premium, Beveridge-Nelson decomposition

JEL Classification: G12, F31

Suggested Citation

Goto, Shingo and Xu, Yan and Zhang, Yuzhao, Currency Risk Premium, Interest Rate Differentials, and the Holding Period (March 2014). Available at SSRN: https://ssrn.com/abstract=2399492 or http://dx.doi.org/10.2139/ssrn.2399492

Shingo Goto

University of Rhode Island - College of Business Administration ( email )

Kingston, RI 02881
United States
4018744318 (Phone)
4018744312 (Fax)

Yan Xu (Contact Author)

HKU, Faculty of Business and Economics ( email )

Pok Fu Lam Road
Hong Kong
Hong Kong

Yuzhao Zhang

Rutgers, The State University of New Jersey - Department of Finance ( email )

94 Rockafeller Road
Piscataway, NJ 08854
United States

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