The missing risk premium in exchange rates

Keywords: Currency returns, forward premium puzzle, present-value model, real exchange rates, uncovered interest rate parity.
  • 26 Junio 2017

Por Magnus Dahlquist (Stockholm School of Economics) y Julien Penasse (University of Luxembourg).


It is well known that the interest rate differential (the forward premium) predicts currency returns. However, we find that the real exchange rate, not the interest rate differential, is the main predictor of currency returns at longer horizons. We relate this finding to other puzzling features of currency markets, namely that the real exchange rate contemporaneously appreciates with the interest rate differential and that the positive relationship between currency risk premia and the interest rate differential reverses over longer horizons. Models in which the currency risk premium depends on the interest rate differential and a missing risk premium, capturing deviations from the purchasing power parity, can rationalize these observations.

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