DP12893-2 | Multihorizon Currency Returns and Purchasing Power Parity

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Exposures of expected future depreciation rates to the current interest rate differential violate the UIP hypothesis in a distinctive pattern that is a non-monotonic function of horizon. Conversely, forward, risk-adjusted expected depreciation rates are monotonic. We explain the two patterns by incorporating the weak form of PPP into a no-arbitrage joint model of the depreciation rate, inflation differential, domestic and foreign yield curves. Short-term departures from PPP generate the first pattern. The risk premiums for these departures generate the second pattern.