Determinants of Currency Risk Premiums - FEDERAL RESERVE BANK of NEW YORK

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Staff Reports

Determinants of Currency Risk Premiums

March 1999 Number 70

JEL classification: F31, F47

Authors: John A. Carlson and C. L. Osler

This paper presents a theoretical model of exchange-rate determination intended to address the forward premium puzzle. It also explains the empirical observation that risk premiums depend on interest differentials. The model's closed-form solution indicates that currency risk premiums depend on two factors: interest differentials and the current deviation of the exchange rate from its long-run equilibrium. If speculators have an alternative to exchange-rate speculation, then there is no presumption that uncovered interest parity holds even approximately in long-run equilibrium. The model is consistent with existing evidence suggesting that forward premiums are negatively related to rationally expected future exchange rate changes. New empirical evidence is provided in support of the model.

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42 pages / 136 kb

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