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Properties of Foreign Exchange Risk Premia

Sarno, Lucio and Schneider, Paul and Wagner, Christian (2010): Properties of Foreign Exchange Risk Premia.

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Abstract

We study the properties of foreign exchange risk premia that can explain the forward bias puzzle - the tendency of high-interest rate currencies to appreciate rather than depreciate. These risk premia arise endogenously from imposing the no-arbitrage condition on the relation between the term structure of interest rates and exchange rates, and they compensate for both currency risk and interest rate risk. In our empirical analysis, we estimate risk premia using an affine multi-currency term structure model and find that model-implied risk premia yield unbiased predictions for exchange rate excess returns. While interest rate risk affects the level of risk premia, the time-variation in excess returns is almost entirely driven by currency risk. Furthermore, risk premia are (i) closely related to global risk aversion, (ii) countercyclical to the state of the economy, and (iii) tightly linked to traditional exchange rate fundamentals.

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