Working Paper: NBER ID: w5623
Authors: David Backus; Silverio Foresi; Chris Telmer
Abstract: Perhaps the most puzzling feature of currency prices is the tendency for high interest rate currencies to appreciate, when the expectations hypothesis suggests the reverse. Some have attributed this forward premium anomaly to a time-varying risk premium, but theory has been largely unsuccessful in producing a risk premium with the requisite properties. We characterize the risk premium in a general arbitrage-free setting and describe the features a theory must have to account for the anomaly. In affine models, the anomaly requires either that state variables have asymmetric effects on state prices in different currencies or that we abandon the common requirement that interest rates be strictly positive.
Keywords: currency pricing; forward premium anomaly; risk premium
JEL Codes: F31; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| higher interest rates (E43) | expected currency appreciation (F31) |
| forward premiums (G13) | subsequent depreciation rates (E43) |
| risk premium (G19) | expected rate of depreciation (E43) |
| differences in conditional means (C29) | differences in conditional higher moments of pricing kernels (G19) |
| state variables (C29) | state prices (P22) |