Exchange Rate Predictability, Risk Premiums, and Predictive System

Uncovered interest rate parity is known to perform poorly in forecasting exchange rate movements, especially in the short run. One possible reason for this failure is the existence of unobservable risk premium. We estimate the unobservable risk premium with a predictive system using the implied volatility of at-the-money currency options as an imperfect predictor. We find that expected exchange rate changes, constructed from forward-spot differentials and estimated risk premiums, track actual exchange rate changes more closely than do the fitted values of the Fama regression. When we add the estimated risk premium from the predictive system in the Fama regression, the UIP puzzle becomes weakened. An out-of-sample analysis reveals that adding the estimated risk premium greatly improves the short-run predictability of exchange rates.