Predictable Currency Risk Premia

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Executive Summary

Currency excess returns are highly predictable, more than stock returns, and about as much as bond returns. Author shows that in a general, no-arbitrage setup, expected currency excess returns have two components: a dollar risk premium and a carry trade risk premium. The average forward discount across all countries is a good measure of the market price demanded by US investors for bearing US-specific risk, and thus a good predictor of currency excess returns. US-specific variables that predict the dollar risk premium have no forecasting power on the carry trade risk premium. These findings point towards a risk-based view of exchange rates.

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