The Real Exchange Rate, Real Interest Rates, and the Risk Premium
The well-known uncovered interest parity puzzle arises from the empirical regularity that, among developed country pairs, the high interest rate country tends to have high expected returns on its short term assets. At the same time, another strand of the literature has documented that high real interest rate countries tend to have currencies that are strong in real terms - indeed, stronger than can be accounted for by the path of expected real interest differentials under uncovered interest parity. These two strands - one concerning short-run expected changes and the other concerning the level of the real exchange rate - have apparently contradictory implications for the relationship of the foreign exchange risk premium and interest-rate differentials. This paper documents the puzzle, and shows that existing models appear unable to account for both empirical findings. The features of a model that might reconcile the findings are discussed.
I thank Bruce Hansen and Ken West for many useful conversations and Mian Zhu for super research assistance. I thank David Backus, Gianluca Benigno, Cosmin Ilut, Keyu Jin, Richard Meese, Michael Melvin, Anna Pavlova, John Prins, Alan Taylor, and Adrien Verdelhan for comments on an earlier draft of the paper. I have benefited from support from the following organizations at which I was a visiting scholar: Federal Reserve Bank of Dallas, Federal Reserve Bank of St. Louis, Federal Reserve Board, European Central Bank, Hong Kong Institute for Monetary Research, Central Bank of Chile, and CREI. I acknowledge support from the National Science Foundation grant no. 0451671. The views expressed herein are those of the author and do not necessarily reflect the views of the National Bureau of Economic Research.