Rethinking Deviations From Uncovered Interest Parity: the Role of Covariance Risk and Noise

Abstract

We examine the ability of the standard intertemporal asset pricing model and a model of noise trading to explain why the forward foreign exchange premium predicts the future currency depreciation with the ‘wrong’ sign. We find that the intertemporal asset pricing model is unable to predict risk premia with the correct sign to be consistent with the data. The noise‐trader model, while highly stylised, receives fragmentary support from empirical research on survey expectations.