Abstract
We use a present-value model of the real exchange rate to impose structure on the cur-rency risk premium. We allow the currency risk premium to depend on both the inter-est rate differential and a latent component: the missing risk premium. Consistent with the data, our present-value model implies that the real exchange rate should predict cur-rency returns. We find that the missing risk premium, not the interest rate differential, explains most of the variation in the real exchange rate. Moreover, our model sheds light on puzzling relations between the interest rate differential, the real exchange rate, and the currency risk premium. (c) 2021 The Authors. Published by Elsevier B.V. This is an open access article under the CC BY license ( http://creativecommons.org/licenses/by/4.0/ )