Exchange Rate Risk and Deviations From Purchasing Power Parity

This paper proposes a new solution to the purchasing power parity (PPP) puzzles, arguing that investors' higher‐order risk attitudes, combined with higher‐order uncertainty about nominal exchange rates, as reflected by skewness and kurtosis, drive a risk premium that leads to deviations from PPP. Analysing US dollar exchange rates against the currencies of three major net exporting countries to the US – Canada, Japan, and the European Union – we find that the skewness of the expected nominal exchange rate is the most significant and statistically robust moment‐based factor influencing these deviations. Our estimates further suggest that only low to moderate exchange rate risks generate risk premia that contribute to these PPP deviations.