Risk and Return in the Foreign Exchange Market : Measurement without VARs

This paper offers a detailed investigation of the foreign exchange risk premium using a structural relationship in the inflation-index bond market, firstly introduced by Clarida (2012). Unlike the conventional VAR approach, this approach estimates risk premium through the non-arbitrage relationship between investing inflation-indexed bonds from two countries and works on the market information set. A rise in the estimated foreign currency risk premium helps to forecast dollar depreciation in subsequent periods. And the forecasting power is stronger than that of the other existing VAR approaches