Working Paper: CEPR ID: DP8503
Authors: Lucio Sarno; Paul Schneider; Christian Wagner
Abstract: 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 the no-arbitrage condition relating the term structure of interest rates and exchange rates. Estimating affine (multi-currency) term structure models reveals a noticeable tradeoff between matching depreciation rates and accuracy in pricing bonds. Risk premiums implied by our global affine model generate unbiased predictions for currency excess returns and are closely related to global risk aversion, the business cycle, and traditional exchange rate fundamentals.
Keywords: Exchange Rates; Forward Bias; Predictability; Term Structure
JEL Codes: E43; F31; G10
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| risk premiums (G19) | exchange rate movements (F31) |
| global risk aversion (D81) | exchange rate movements (F31) |
| macroeconomic variables (E19) | exchange rate movements (F31) |
| omission of risk premiums (G19) | forward bias (G40) |
| interest rates (E43) | exchange rate behavior (F31) |