A Currency Premium Puzzle

We show that quantitative asset pricing models, built to address the equity premium and risk-free rate puzzles, systematically fail when applied to open economies: they cannot generate the large and persistent interest rate differentials we observe between risky and safe currencies. This failure stems from the key mechanism that produces their success in matching both closed-economy puzzles: In these models, the mean of the stochastic discount factor offsets its variance nearly one-for-one, which immobilizes interest rates --- so that differences in expected currency returns across countries must arise almost exclusively from predictable changes in exchange rates, at odds with the data. We prove this result in a broad class of models that allows for market incompleteness and exchange rate disconnect, requiring only that each country's risk-free asset is priced by investors who demand compensation for risk in line with observed risk premia. We argue this tension between canonical asset pricing and international macroeconomic models is a key reason researchers have struggled to reconcile the observed behavior of exchange rates, interest rates, and capital flows across countries.