Currency Risk Premium, Interest Rate Differentials, and the Holding Period
47 Pages Posted: 23 Feb 2014 Last revised: 9 Apr 2014
Date Written: March 2014
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: Suggested Citation