Abstract
Several long-standing puzzles in the currency market have been reversed over the last decade or so, including the forward premium puzzle, carry trade profitability and the exchange rate disconnect. We provide a common framework for understanding these reversals, relying essentially on the structural breaks that we find in currency returns at the end of 2005. Our model-based evidence shows that these reversals can be explained by a shift in the relative importance of the global and local risk factors that drive currency returns. We associate this shift with (i) developments in the U.S. oil sector, (ii) changing impact of the oil price on U.S. inflation, and (iii) weaker links between the real interest rates in the advanced economies, that all originate around the end of 2005.
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