 Exchange rate predictability, risk premiums, and predictive systemYuhyeon Bak and Cheolbeom Park Economic Modelling, 2022, vol. 116, issue C Abstract: Uncovered interest rate parity (UIP), a basic assumption in many theoretical models, is known to perform poorly in forecasting exchange rate movements, especially in the short run. One possible reason for this failure is the existence of unobservable risk premium. We estimate the unobservable risk premium with a Bayesian approach having the risk premium as a latent variable and the implied volatility of at-the-money currency options as an imperfect predictor. We find in most cases that expected exchange rate changes, constructed from forward-spot differentials and estimated risk premiums, track actual exchange rate changes more closely than do the fitted values of the predictive regression (i.e. the Fama regression). An out-of-sample analysis reveals that adding the estimated risk premium greatly improves the short-run predictability of exchange rates in general. These findings strongly suggest that the risk premium is important in understanding the dynamics of exchange rate and the UIP puzzle. Keywords: Exchange rate; Bayesian approach; Predictive system; Risk premium (search for similar items in EconPapers) Downloads: (external link) Related works: Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text Persistent link: https://EconPapers.repec.org/RePEc:eee:ecmode:v:116:y:2022:i:c:s0264999322002632 DOI: 10.1016/j.econmod.2022.106024 Access Statistics for this article Economic Modelling is currently edited by S. Hall and P. Pauly More articles in Economic Modelling from Elsevier |
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