Properties of Foreign Exchange Risk Premiums

We study the properties of foreign exchange risk premiums that can explain the forward bias puzzle, defined as the tendency of
high-interest rate currencies to appreciate rather than depreciate.
These risk premiums arise endogenously from the no-arbitrage
condition relating the term structure of interest rates and exchange
rates. Estimating affine (multi-currency) term structure models
reveals a noticeable tradeoff between matching depreciation rates
and accuracy in pricing bonds. Risk premiums implied by our global
affine model generate unbiased predictions for currency excess
returns and are closely related to global risk aversion, the
business cycle, and traditional exchange rate fundamentals.