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Properties of Foreign Exchange Risk Premiums

Sarno, Lucio (2010): Properties of Foreign Exchange Risk Premiums.

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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 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 the empirical analysis, we estimate risk premiums using an affine multi-currency term structure model and find that model-implied risk premiums yield unbiased predictions for exchange rate excess returns. While interest rate risk affects the level of risk premiums, the time variation in excess returns is almost entirely driven by currency risk. Furthermore, risk premiums are closely related to global risk aversion, countercyclical to the state of the economy, and tightly linked to traditional exchange rate fundamentals.

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