Information Risk in the International Currency Markets: Evidence from the Violation of UIRP

Drawing on the theoretical and empirical evidence that private information risk is priced in the expected returns of equities, we hypothesize that information risk premium is an important component of the risk premium that leads to the violation of uncovered interest rate parity (UIRP). Using an asset pricing model in which the risk factors are a world currency factor, a world equity factor, and a world private information factor, we find that UIRP is violated for 28 single currencies plus the euro and that violation is due to the existence of a significant time-varying risk premium. The component of the risk premium attributable to private information is economically large, statistically significant, and frequently dominates the component due to the world equity and currency factors, respectively. As far as we are aware, this is the first evidence that information risk is priced in assets other than equities and in the international financial markets. Together, the factors explain the average currency excess returns (alpha is equal zero) suggesting that, contrary to recent studies, UIRP is violated because investors require a risk premium on their currency deposits. We show that proxies for the country’s information environment explain the cross-sectional variation of exposures to private information risk.