Handbook of Exchange Rates

14.1 Introduction

According to the uncovered interest rate parity (UIP) condition, expected changes in exchange rates should be equal to the interest rate differentials between foreign and domestic risk-free bonds. The UIP condition implies that a regression of exchange rate changes on interest rate differentials should produce a slope coefficient of 1. Instead, empirical work following Hansen and Hodrick (1980) and Fama (1984) consistently reveals a slope coefficient that is smaller than 1 and very often negative. The international economics literature refers to these negative UIP slope coefficients as the UIP puzzle or forward premium anomaly.

Negative slope coefficients mean that currencies with higher

than average interest rates tend to appreciate and not to depreciate as UIP would predict. Investors in foreign one-period discount bonds, thus, earn the interest rate spread, which is known at the time of their investment, plus the bonus from the currency appreciation during the holding period. As a result, the forward premium anomaly implies positive predictable excess returns for investments in high interest rate currencies and negative predictable excess returns for investments in low interest rate currencies. There are two possible explanations for these predictable excess returns: time-varying risk premia and expectational errors.¹

In this chapter, we survey empirical and theoretical risk-based approaches of exchange rates. In Section 14.2, we start by laying down the basic ...