The yen–dollar risk premium: A story of regime shifts in bond markets

Abstract

We document a new risk premium in the yen–dollar currency pair that compensates for the uncertainty over regime shifts in the bond market. We estimate a no-arbitrage regime-switching term structure model, where the transition of volatility regimes is driven by the level of yields and is associated with a regime risk premium. We find that the currency excess return is explained by the regime risk premium in Japan in the second half of 1990s and in the US at the height of the Great Recession. The regime risk premium contains information beyond the affine model, the forward premium, and the carry and dollar factors.