Long-Term Foreign Exchange Risk Premia and Inflation Risk

Abstract

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.

Keywords: Foreign exchange risk premia, real interest rates, inflation risk, affine term structure model, inflation volatility

JEL Classification: E43, F31, G15