Currency Risk and Imperfect Knowledge: Volatility and Long Swings around Benchmark Values

This study tests several models of the currency risk premium, but does so using survey data on traders' forecasts to directly measure the expected excess return. Among those tested are UIP, CAPM, and the Imperfect Knowledge Economics (IKE) gap model, which respectively imply that the premium is zero, related to the variance of the exchange rate, and related to the deviation between the exchange rate and its benchmark value of Purchasing Power Parity (PPP). The main result is that the p-value testing the restrictions of the models is between .26-.61 greater for the IKE model than for the traditional models. An effect of the volatility can be detected, but primarily in the short-run dynamics and only after controlling for the gap effect of how far the exchange rate is from PPP. This suggests that the difficulty in the previous literature to find the hypothesized effect of volatility was, in part, an omitted variable bias.