Determinants of Currency Risk Premiums

The risk premium is a function of both the interest rate differential and the gap between the current exchange rate and its long-run equilibrium in a model of the foreign exchange market with both non-speculating traders and rational speculators. If the speculators have an alternative to specializing in exchange-rate speculation, then there should be no presumption that uncovered interest parity will hold even approximately with a long-run equilibrium number of speculators. Furthermore, when other traders respond to interestrate differentials, the model can give rise to a negative relationship between the interestrate differential and the subsequent change in the exchange rate, a phenomenon that is often evident in foreign exchange markets. * The views in this paper are those of the authors and do not necessarily reflect those of the Federal Reserve Bank of New York or the Federal Reserve System. Carlson wishes to thank the Purdue Center for International Business Education and Research for financial support. ., DETERMINANTS OF CURRENCY RISK PREMIUMS One of the most intriguing empirical results in the area of international money and finance is the phenomenon of forward discount bias. Under the familiar conditions of uncovered interest parity and rational expectations, the forward premium (that is, the difference between the forward exchange rate and the current spot rate) should be an unbiased predictor of future exchange-rate changes. Existing evidence shows, however, that the actual change in a spot exchange rate is poorly predicted by the forward premium. In fact, the implied prediction is seriously biased and often has the wrong sign (proot and Thaler 1990, Engel 1996, Lewis 1995). Another implication of the joint hypothesis of uncovered interest parity and rational expectations is that rationally expected excess returns, often referred to as risk premiums, should be identically zero. As a corollary, the empirically identified forward bias implies the existence of a non-zero risk premium. Though the existence of forward bias was identified almost two decades ago, empirical research has not been successful at reconciling the behavior of risk premiums with existing theoretical models. When confronted with actual data on risk premiums, the models generally have extremely low explanatory power, and theoretically important variables are frequently statistically insignificant. The relationship between risk premiums and interest differentials is a particularly puzzling aspect of this mystery. Many empirical studies have concluded that risk premiums are strongly related to interest differentials. This is true for studies in which