Foreign Exchange Risk Premium Determinants: Case of Armenia

Abstract

This paper studies foreign exchange risk premium using the uncovered interest rate parity framework in a single country context. The analysis is performed using weekly data on foreign and domestic currency deposits in Armenian banking system. The paper provides the results of the simple tests of uncovered interest parity condition, which indicate that contrary to established view dominating in empirical literature there is a positive correspondence between exchange rate depreciation and interest rate differentials in Armenian deposit market. Furthermore, the paper presents and discusses a systematic positive risk premium required by the economic agents for foreign exchange transactions, which increases over the investment horizon. The two currency affine term structure framework is applied to identify the factors driving the systematic exchange rate risk premium in Armenia. At the end, possible directions for further research are outlined.

Keywords: "forward discount" puzzle, exchange rate risk, affine term structure models, foreign

JEL Classification: E43, E58, F31, G15, O16, P20