A Mean-Reverting Model of Exchange Rate Risk Premium Using Ornstein-Uhlenbeck Dynamics
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arXiv
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| Format: | Preprint |
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2025
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| _version_ | 1866917980886007808 |
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| author | Hwang, SeungJae |
| author_facet | Hwang, SeungJae |
| contents | This paper examines the empirical failure of uncovered interest parity (UIP) and proposes a structural explanation based on a mean-reverting risk premium. We define a realized premium as the deviation between observed exchange rate returns and the interest rate differential, and demonstrate its strong mean-reverting behavior across multiple horizons. Motivated by this pattern, we model the risk premium using an Ornstein-Uhlenbeck (OU) process embedded within a stochastic differential equation for the exchange rate.
Our model yields closed-form approximations for future exchange rate distributions, which we evaluate using coverage-based backtesting. Applied to USD/KRW data from 2010 to 2025, the model shows strong predictive performance at both short-term and long-term horizons, while underperforming at intermediate (3-month) horizons and showing conservative behavior in the tails of long-term forecasts. These results suggest that exchange rate deviations from UIP may reflect structured, forecastable dynamics rather than pure noise, and point to future modeling improvements via regime-switching or time-varying volatility. |
| format | Preprint |
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arxiv_https___arxiv_org_abs_2504_06028 |
| institution | arXiv |
| publishDate | 2025 |
| record_format | arxiv |
| spellingShingle | A Mean-Reverting Model of Exchange Rate Risk Premium Using Ornstein-Uhlenbeck Dynamics Hwang, SeungJae Computational Finance Statistical Finance 91G80, 60J60 This paper examines the empirical failure of uncovered interest parity (UIP) and proposes a structural explanation based on a mean-reverting risk premium. We define a realized premium as the deviation between observed exchange rate returns and the interest rate differential, and demonstrate its strong mean-reverting behavior across multiple horizons. Motivated by this pattern, we model the risk premium using an Ornstein-Uhlenbeck (OU) process embedded within a stochastic differential equation for the exchange rate. Our model yields closed-form approximations for future exchange rate distributions, which we evaluate using coverage-based backtesting. Applied to USD/KRW data from 2010 to 2025, the model shows strong predictive performance at both short-term and long-term horizons, while underperforming at intermediate (3-month) horizons and showing conservative behavior in the tails of long-term forecasts. These results suggest that exchange rate deviations from UIP may reflect structured, forecastable dynamics rather than pure noise, and point to future modeling improvements via regime-switching or time-varying volatility. |
| title | A Mean-Reverting Model of Exchange Rate Risk Premium Using Ornstein-Uhlenbeck Dynamics |
| topic | Computational Finance Statistical Finance 91G80, 60J60 |
| url | https://arxiv.org/abs/2504.06028 |