The missing risk premium in exchange rates

Puzzling exchange rate dynamics and delayed portfolio adjustment

“…We set the home bias parameter h equal to 0.66, which is the average for the countries during Q2, 2017. 16 Details regarding the data for this calibration can be found in Appendix A.…”

“…It does not affect any of the other results. 16 We combine BIS data on debt securities outstanding with external assets and liabilities for debt securities from the IMF International Investment Position Statistics. 17 A rate of risk aversion of 50 may seem very large, but analogous to the equity premium, which requires a very high rate of risk aversion to explain, currency premia are very small for low rates of risk aversion.…”

“…Dependent on parameters, predictability reversal can also happen when α + ρ < 1. 23 See also Dahlquist and Penasse (2017).…”

“…Engel (2016), Itshkoki and Mukhin (2017), and Vlachev (2017) propose explanations based on liquidity shocks. Chernov and Creal (2018) and Dahlquist and Penasse (2017) focus on the role of long-term real exchange rate adjustment. The forward guidance exchange rate puzzle and LSV puzzle have only been recently documented and no solution has been proposed yet.…”

“…Chernov and Creal (2018) andDahlquist and Penasse (2017) argue that there is a missing risk premium that should be related to the real exchange rate. Their proposed specification is however different from ours in equation(12).…”