The missing risk premium in exchange rates

Magnus Dahlquist and Julien Penasse

Journal of Financial Economics, 2022, vol. 143, issue 2, 697-715

Abstract: 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 return; Forward premium puzzle; Purchasing power parity; State-space model; Uncovered interest rate parity (search for similar items in EconPapers)
JEL-codes: E43 F31 G15 (search for similar items in EconPapers)
Date: 2022
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Citations: View citations in EconPapers (11)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:jfinec:v:143:y:2022:i:2:p:697-715

DOI: 10.1016/j.jfineco.2021.07.001

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