Exchange Rates, Interest Rates, and the Risk Premium

The uncovered interest parity puzzle concerns the empirical regularity that high interest rate countries tend to have high expected returns on short term deposits. A separate puzzle is that high real interest rate countries tend to have currencies that are stronger than can be accounted for by the path of expected real interest differentials under uncovered interest parity. These two findings have apparently contradictory implications for the relationship of the foreign-exchange risk premium and interest-rate differentials. We document these puzzles, and show that existing models appear unable to account for both. A model that might reconcile the findings is discussed. (JEL E43, F31, G15)

The Foreign Exchange Risk Premium A Disaggregate Approach

<p class="MsoBodyText" style="margin: 0in 0.5in 0pt;"><span style="mso-bidi-font-style: italic;"><span style="font-size: x-small;"><span style="font-family: Times New Roman;">This paper re-examines the issue of the existence of a time-varying risk premia in the three foreign exchange markets. By using the theoretical framework developed by Domowitz and Hakkio it relates the risk premium in the foreign exchange market with the heterogeneity across the market participants. The empirical research using a disaggregate survey data base support the importance is supportive of the existence of time-varying risk premia for the British Pound, German Mark and Japanese Yen exchange rates. In particular, we demonstrate that consensus measures of the risk premium mask the existence because of the importance of heterogenous expectations.</span></span></span></p>