Foreign Exchange Risk Premium Research Articles

User cost of foreign monetary assets under dollarization

We use a Capital Asset Price Model (CAPM) model to derive the formula of user cost for foreign monetary asset whose rates of return are subject to foreign exchange risk premia. Our formula shows that only domestic non-monetary asset can be used as the benchmark asset. In fact, under dollarization the local currency’ assets offer a higher risk premium and return over the dollar denominated one because the latter is preferred over the first for hedging motives. Using data from Chile (from June 2003 to January 2022) and Croatia (from December 2011 to March 2022), our results show that the inclusion of the currency risk premium has improved substantially the formula proposed by Barnett (1978).

Pricing the Excess Volatility in Foreign Exchange Risk Premium and Forward Rate Bias

ABSTRACT We present the pricing of the documented excess volatility of the foreign exchange risk premium, relative to the interest rate differential. By specifying a term structure of interest rate model, the physical probability measure along with the pricing kernels or discount factors are used to derive a system for the expected future spot rate and the forward rate. The theoretical loads are found by solving the Riccati ordinary differential equations, and dynamic factors are captured to set up the global factors for both currencies. It shows that we prove the interest-rate surfaces are almost identical to the empirical ones, and the theoretical interest rates are guaranteed to be positive.

Long-term foreign exchange risk premia and inflation risk

As highlighted by recent literature, long-term foreign exchange risk premia (FRP) of a currency pair tend to covary negatively with short-term real interest rate differentials (RIRD) of the pair. We fit an affine term structure model for 9 major currencies against the US dollar and estimate two components of this covariance: the real risk premia (RRP) component and the inflation risk premia differential (IRPD) component. We find that the IRPD component is significantly negative for all currency pairs in our sample. We propose a macro-finance model to understand the types of shocks that generate such covariance.

The Foreign Exchange Risk Premium in the Cross-Section of Stock Returns: International Evidence

Using the framework of the International Capital Asset Pricing Model, we estimate unconditional FX risk premiums for a large cross-section of firms from local currency perspectives. Further, we study the impact of potential FX risk diversifiability on FX risk premiums. Using equity data from nine major financial markets, we find support for FX risk being a contributing factor to stock return volatility in eight and a priced factor in four of the sample markets. Empirical estimates of FX risk premiums are economically meaningful, negative for U.S. and Swiss firms, and positive for Australian and Canadian firms.

A Reconsideration of the Failure of Uncovered Interest Parity for the U.S. Dollar

We re-examine the time-series evidence for failures of uncovered interest rate parity on short-term deposits for the U.S. dollar versus major currencies of developed countries at short-, medium- and long-horizons. The evidence that interest rate differentials predict foreign exchange risk premiums is fragile. The relationship between interest rates and excess returns is not stable over time and disappears altogether when nominal interest rates are near the zero-lower bound. However, we do find evidence that year-on-year inflation rate differentials consistently predict excess returns – when the U.S. dollar y.o.y. inflation rate has been relatively high, subsequent returns on U.S. deposits tend to be high. We interpret this evidence as being consistent with hypotheses that posit that markets do not fully react initially to predictable changes in future monetary policy. Interestingly, the predictive power of relative y.o.y. inflation only begins in the mid-1980s when central banks began to target inflation more consistently and continues in the post-ZLB period when interest rates lose their primacy as a policy instrument. However, we caution not to rule out the possibility that excess returns are not predictable at all.

Exchange Rates and Liquidity Risk

I use Forex trading data to study how risks associated with the lack of liquidity contribute to the dynamics of 17 spot exchange rates through their time-varying contributions to risk premia. I find that liquidity risk matters. All the foreign exchange risk premia compensate investors for exposure to liquidity risk; and, for many currencies, exposure to liquidity risk appears to be more important than exposure to the traditional carry and momentum risk factors. I also find that variations in the price of liquidity risk make economically important contributions to the behavior of individual foreign currency returns: they account for approximately 34%, on average, of the variability in currency returns compared to the contribution of approximately 8% from the prices of carry and momentum risk.

Exchange Rates and Liquidity Risk

I use Forex trading data to study how risks associated with the lack of liquidity contribute to the dynamics of 17 spot exchange rates through their time-varying contributions to risk premia. I find that liquidity risk matters. All the foreign exchange risk premia compensate investors for exposure to liquidity risk; and, for many currencies, exposure to liquidity risk appears to be more important than exposure to the traditional carry and momentum risk factors. I also find that variations in the price of liquidity risk make economically important contributions to the behavior of individual foreign currency returns: they account for approximately 34 percent, on average, of the variability in currency returns compared to the contribution of approximately 8 percent from the prices of carry and momentum risk.

Long-Term Foreign Exchange Risk Premia and Inflation Risk

As highlighted by recent literature, long-term foreign exchange risk premia (FRP) of a currency pair tend to covary negatively with short-term real interest rates differentials (RIRD) of the pair. We fit an affine term structure model for 9 major currencies against the US dollar and estimate two components of this covariance: the real risk premia (RRP) component and the inflation risk premia differential (IRPD) component. We find that the IRPD component is significantly negative for all currency pairs in our sample. We propose a macro-finance model to understand the type of shocks that generates such covariance.

Hedge accounting and investors’ view of FX risk

Purpose This paper aims to examine the foreign exchange (FX) risk effects of cash flow hedge accounting (HA). To the extent the HA qualification criteria and detailed documentation give investors confidence that FX derivatives effectively hedge risk, market-assigned FX risk premiums will be lower for firms using cash flow HA. Design/methodology/approach Probit analyses rely on the HA designation to examine the decision to use cash flow HA. Primary analyses test the hypothesized relationship between the magnitude of FX risk premiums and such HA use. Additional analyses allow for the interaction between cash flow HA use and the extent of FX derivatives use. Findings Hypothesis tests indicate that the magnitude of the FX risk premium is, on average, lower for firms designated as effective cash flow hedgers. In additional tests, the evidence suggests that the market assigns a lower FX risk premium to firms using a higher level of FX derivatives as effective cash flow hedges. Practical implications The findings suggest that cash flow HA provides risk-relevant information to investors. Such positive effects of HA on investors’ understanding of risk management may guide US accounting regulators in their efforts to improve HA. Corporate treasurers also may benefit from these insights into evaluating the use of HA. Originality/value Responding to the call for research on the risk relevance of cash flow HA, this paper merges the HA literature with the FX risk management literature to directly examine the relationship between HA use and FX risk premiums for manufacturing firms. The authors take an innovative approach using FX rates to which each firm is most exposed and provide evidence consistent with the argument that this approach is helpful in understanding both the decision to use cash flow HA and the effect of such HA use on market-assigned FX risk premiums.

Capital Control and Monetary Policy in Asian Emerging Market Economies

This paper explores two policy options in emerging market economies (EMEs) to cope with volatile capital flows due to external monetary policy shocks; capital control policy and choice of exchange rate regime. Both tools reinforce each other when a foreign exchange risk premium shock hits the economy. A contractionary U.S. monetary policy shock has significant real effects in EMEs. Conventional wisdom tells us that a free floating exchange rate with inflation targeting is better when a country faces foreign shocks. However, we show that a flexible exchange rate with less capital controls is not the best option in EMEs based on vector autoregression analysis. Moreover, we set up a small open economy new Keynesian model with real wage and price rigidities. It shows that the small economy with labor market frictions is more vulnerable to exogenous shocks such as a foreign exchange rate shock under a fixed exchange rate regime than under a flexible exchange regime. We show that maintaining price stability is not desirable when there are substantial frictions in the labor market and the intratemporal elasticity of substitution is high. Finally, the model shows that the welfare cost difference between a policy of maintaining purchasing power and a policy aimed at price stability reverses as the intratemporal elasticity of substitution between home and foreign goods increases.

Unconventional Monetary Policy and International Risk Premia

AbstractWe assess the relationship between monetary policy, foreign exchange risk premia, and term premia including the period at the zero lower bound (ZLB). We estimate a structural vector autoregression including U.S. and foreign interest rates and exchange rates and identify monetary policy shocks through a method that uses high‐frequency monetary policy surprises as the external instrument that achieves identification without using implausible restrictions. We split out effects of different types of monetary policy surprises that apply at the ZLB, including forward guidance and asset purchases. This allows us to measure the effects of policy shocks on expectations, and hence risk premia.

Risk Premium Estimation in the Colombian Foreign Exchange Market

We studied the foreign exchange risk premium in the Colombian market for the USD/COP exchange rate. Likewise most literature, we consider the existence of the risk premium, as we assessed the problem considering future contracts prices and spot prices at four different times of the morning. Furthermore, we found statistically significant evidence to consider the risk premium as time-varying due to different results in the estimations depending of the time of the day. Finally, in contrast with the early morning regressions, we encountered evidence that the estimation of the foreign exchange risk premium was statistically significant only in late hours of the morning, i.e., only at 11:00 and 12:00 suggesting that the exchange market may valuate more adequately the futures in the late morning hours. This can be explained by the fact that early transactions have higher volatility and may miss important information that the market include as the day advances.

Unconventional Monetary Policy and International Risk Premia

We assess the relationship between monetary policy, foreign exchange risk premia and term premia at the zero lower bound. We estimate a structural VAR including U.S. and foreign interest rates and exchange rates, and identify monetary policy shocks through a method that uses these surprises as the crucial "external instrument" that achieves identification without having to use implausible short-run restrictions. This allows us to measure effects of policy shocks on expectations, and hence risk premia. U.S. monetary policy easing shocks lower domestic and foreign bond risk premia, lead to dollar depreciation and lower foreign exchange risk premia. We present some evidence that U.S. monetary policy easing surprises at the ZLB shift options-implied skewness in the direction of dollar depreciation and also reduce the demand for the liquidity of short-term U.S. Treasuries. Both of these channels should lower foreign exchange risk premia.

Currency Carry Trade and Bank's Foreign Exchange Risk Management

The role of the market makers is crucial in determining the foreign exchange risk premium in currency carry trade. A typical market maker of foreign exchange is a highly leveraged commercial bank or investment bank. I derive a model of foreign exchange risk premium from the perspective of a market maker, in which the required foreign exchange risk premium is proportional to the volatility of foreign exchange rate, the net foreign exchange exposure, and the financial leverage. The financial leverage amplifies small changes in net foreign exposure and volatility into large changes in the risk premium. This amplifier effect offers an explanation to the foreign exchange risk premium puzzle. I use this model to examine the negative interest rate differential between Japan and the U.S. in the 1990s.

Foreign Exchange Risk Premia and Goods Market Frictions

Foreign Exchange Risk Premia and Goods Market Frictions-Foreign Exchange Risk Premium, Forward Premium Anomaly, Random Walk Behaviors, Staggered Price Setting, Interest-sensitive Money Demand, Monetary Shocks

Exchange Rates, Interest Rates, and the Risk Premium

The uncovered interest parity puzzle concerns the empirical regularity that high interest rate countries tend to have high expected returns on short term deposits. A separate puzzle is that high real interest rate countries tend to have currencies that are stronger than can be accounted for by the path of expected real interest differentials under uncovered interest parity. These two findings have apparently contradictory implications for the relationship of the foreign-exchange risk premium and interest-rate differentials. We document these puzzles, and show that existing models appear unable to account for both. A model that might reconcile the findings is discussed. (JEL E43, F31, G15)

Foreign exchange risk and the term-structure of industry costs of equity

This paper makes two contributions to the literature. First, we build on the methodology of Ang and Liu (2004) to model the cost of capital term-structure for firms subject to foreign exchange (FX) risk. We emphasize the role of time-varying parameters such as FX risk and factor loadings. Second, we estimate the term-structure for 39 U.S. industries. We find that: 1) FX exposure changes the position and shape of the term-structures; 2) The average FX risk premium is 2.29% for cash flows with short-term maturity, but declines as maturity increases; 3) The pricing error from ignoring the term-structure is smaller than the error resulting from the omission of the FX risk component.

Macroeconomic sources of foreign exchange risk premium: evidence from South Africa

This study investigates the macroeconomic sources of foreign exchange risk premium in South Africa using the stochastic discount factor (SDF) approach based on observable macroeconomic factors. Using the multivariate GARCH-in-mean model with no-arbitrage condition, I find support for the role of nominal and real macroeconomic factors as important determinants of foreign exchange risk premium in South Africa. However, while inflation rate and broad money growth are associated higher risk premium, consumption growth appears to be associated with lower risk premium. Finally, the time varying nature of foreign exchange risk premia in South Africa suggest that, policymakers in South Africa need to broaden their analysis of fluctuations in foreign exchange rates to include an assessment of the foreign exchange risk premia.

Carry Trades and the Performance of Currency Hedge Funds

We investigate the performance and risk of currency hedge funds using a large and unique consolidated currency hedge fund dataset. We find that a substantial number of hedge funds generate returns that exceed foreign exchange risk premia obtained through carry trades. The best alpha-generating funds exhibit a performance that persists over a one-year horizon. This performance persistence is mostly due to compensation for currency risk-taking as there is no strong evidence of remuneration for active management. The results are robust to biases affecting hedge fund returns, alternative carry trade benchmarks and different methodologies used to correct for sample variability.

Carry trades and the performance of currency hedge funds

We investigate the performance and risk of currency hedge funds using a large and unique consolidated currency hedge fund dataset. We find that a substantial number of hedge funds generate returns that exceed foreign exchange risk premia obtained through carry trades. The best alpha-generating funds exhibit a performance that persists over a one-year horizon. This performance persistence is mostly due to compensation for currency risk-taking as there is no strong evidence of remuneration for active management. The results are robust to biases affecting hedge fund returns, alternative carry trade benchmarks and different methodologies used to correct for sample variability.