The missing risk premium in exchange rates
Congratulations Magnus Dahlquist whose paper ”The missing risk premium in exchange rates” written with Julien Pénasse, University of Luxembourg, has been accepted for publication in the Journal of Financial Economics.
Magnus Dahlquist and Julien Pénasse use a present-value model of the real exchange rate to impose structure on the currency risk premium. They allow the currency risk premium to depend on both the interest rate differential and a latent component - the missing risk premium.
Consistent with the data, their present-value model implies that the real exchange rate should predict currency returns. They find that the missing risk premium, not the interest rate differential, explains most of the variation in the real exchange rate. Moreover, the model sheds light on puzzling relationships between the interest rate differential, the real exchange rate, and the currency risk premium.