The Missing Risk Premium in Exchange Rates
71 Pages Posted: 14 Dec 2016 Last revised: 14 Apr 2021
Date Written: October 27, 2020
We use a present-value model of the real exchange rate to impose structure on the currency risk premium. We allow the currency risk premium to depend on both the interest rate differential and a latent component—the missing risk premium. Consistent with the data, our present-value model implies that the real exchange rate should predict currency returns. We find that the missing risk premium, not the interest rate differential, explains most of the variation in the real exchange rate. Moreover, our model sheds light on puzzling relations between the interest rate differential, the real exchange rate, and the currency risk premium.
Keywords: Currency returns, forward premium puzzle, purchasing power parity, state-space model, uncovered interest rate parity.
JEL Classification: E43, F31, G15
Suggested Citation: Suggested Citation