Exchange rate returns, ‘news’, and risk premia

Using a new survey data set of matched exchange rate and interest rate expectations for eight currencies relative to the German mark, we examine empirically the relationship between exchange rate returns, ‘news’, and risk premia. ‘News’ on interest differentials enters significantly in equations for the difference between the spot rate and the lagged forward rate for the British pound, Japanese yen, Spanish peseta and the US dollar. An unexpected rise in the interest rate differential tends to strengthen the domestic exchange rate. For each of these currencies, we also find significant effects of our ex ante measure of the risk premium. In addition, we investigate the effect of lagged interest rate differentials as a proxy for the risk premium and find that they do not capture time-varying risk premia as is widely suggested in the literature, but probably reflect a peso problem, learning about a policy change, a market inefficiency, or a combination of these factors.