Exchange rates, expected returns and risk
According to theory, higher expected foreign risk-free returns and foreign currency risk both increase foreign yields, but have opposing effects on the value of the foreign currency. This paper exploits that relationship to jointly identify the unobserved risk-free return and risk premium components of exchange rates and expected relative returns. When risk and return are jointly modelled over a 10-year horizon, UIP cannot be rejected for any of the eight advanced country USD currency pairs examined. Innovations in the currency premium are correlated with 'speculative' positioning in foreign exchange markets, and for non-reserve currencies, with 'VIX' risk aversion. Innovations in the risk-free component are correlated with changes in nominal short-term interest rates. Both expected returns and risk play important roles in exchange rate dynamics.