The link between foreign exchange premia and term structure premia

One of the most inexplicable and enduring puzzles in international finance is the stylized fact that forward exchange rates are biased predictors of future spot exchange rates. This observation is best understood in terms of the failure of the uncovered interest rate parity (UIP) hypothesis. Identifying the source of the failure is important because it has implications for the speculative efficiency of the foreign exchange market. Issues such as the effects of “long swings” in currency values and the proper role of government in stabilizing exchange rate fluctuations depend critically on whether the foreign exchange market can be characterized as efficient. This thesis offers a potential explanation for the failure of UIP and evaluates its implications for foreign exchange market speculative efficiency.; The first essay tests a theory of the failure of UIP based on cross-country differences in term structure premia. It finds that a measure of cross-country differences in term premia is more important in explaining deviations from UIP than a measure of exchange rate risk. This implies that foreign exchange market efficiency is inherently linked to the efficiency of domestic and foreign bond markets. To the extent that term structure premia are rational and efficient, deviations from UIP should also be rational and efficient.; An observation closely associated with the failure of UIP is that the returns on assets of the same maturity differ systematically across countries. An implication of these “excess foreign returns” is the existence of unexploited arbitrage opportunities across a broad range of assets between many currencies. The second essay examines the possibility that excess foreign returns are caused by a foreign investment risk premium. This is done by testing whether excess foreign returns move in proportion to a latent variable, where excess returns are determined by cross-country differences in term structure premia. The results suggest that foreign investment risk is not a significant source of excess foreign returns. Since a risk premium explanation is probably the best hope for explaining deviations from UIP in a manner consistent with simple definitions of efficiency, these findings do not augur well for foreign exchange market speculative efficiency.