Variance Risk Premium Differentials and Foreign Exchange Returns

The uncovered interest rate paritydoes not hold in the foreign exchange market(UIP puzzle). I use the cross-country variance risk premiumdifferential to measure the excess foreign exchange return. Consequently, similar to Bansal and Shaliastovich (2010), I provide a risk-based explanation for the violation of UIP. The empirical results, based on the monthly data of ten currency pairsamong US Dollar, UK Pound, Japanese Yen, Euro, and Swiss Franc, support the model both in-sample and out-of-sample.