The Missing Risk Premium in Exchange Rates

We find that a present-value model in which the currency risk premium depends only on the nominal interest rate differential cannot account for movements in the real exchange rate. We extract a missing risk premium that complements the nominal interest rate differential. This missing risk premium captures deviations from the purchasing power parity and increases the R-squared in predictive regressions of monthly currency returns by more than 30%. The predictability holds in an out-of-sample evaluation and substantially increases with the investment horizon. The missing risk premium helps us understand the challenges facing standard asset pricing models.