Working Paper

A Currency Premium Puzzle

Abstract: Standard asset pricing models reconcile high equity premia with smooth risk-free rates by inducing an inverse functional relationship between the mean and the variance of the stochastic discount factor. This highly successful resolution to closed-economy asset pricing puzzles is fundamentally problematic when applied to open economies: It requires that differences in currency returns arise almost exclusively from predictable appreciations, not from interest rate differentials. In the data, by contrast, exchange rates are largely unpredictable, and currency returns arise from persistent interest rate differentials. We show currency risk premia arising in canonical long-run risk and habit preferences cannot match this fact. We argue this tension between canonical asset pricing and international macroeconomic models is a key reason researchers have struggled to reconcile the observed behavior of exchange rates, interest rates, and capital flows across countries. The lack of such a unifying model is a major impediment to understanding the effect of risk premia on international markets.

Keywords: currency premium; asset pricing; macroeconomic models; exchange rates; interest rates; international capital flows;

https://doi.org/10.24148/wp2024-32

Bibliographic Information

Provider: Federal Reserve Bank of San Francisco

Part of Series: Working Paper Series

Publication Date: 2024-10-18

Number: 2024-32