DP13252 | International yield curves and currency puzzles

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Exchange rates are not spanned by bonds. Thus, one has to incorporate exchange rates into estimation of affine no-arbitrage yield curve models to measure international pricing kernels. That helps with resolving the famous currency puzzles: the estimated model captures UIP violations and exchange rate volatility. Currency risk premiums are at the center of both differences between the US yields and their foreign counterparts, and between the corresponding bond risk premiums. The model suggests variables that are correlated with both currency and bond premiums.