Abstract
In this study, I formulate a present value model of the exchange rate with a risk premium and introduce exchange rate risk exposure as a factor of the persistently time-varying risk premium. The present value model incorporates expectations for the distant future, and therefore, indicates that spot exchange rate variations reflect changes in long-run future interest rate differential and exchange rate expectations, in addition to a risk premium for long-run risk exposure. I also conduct empirical analyses using mainly the USD/JPY rate and other exchange rates against the USD. The Japanese current account balance provides a better estimation of the change in USD/JPY rate market risk exposure as USD invoiced trades are prevalent in Japan. Then, I demonstrate the possibility that a persistently time-varying risk premium offsets the effect of the interest rate differential on exchange rate variations, which can be a solution to the uncovered interest rate parity puzzle.
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