The forward premium puzzle in currency markets is the standard empirical finding that the expected changes in currency exchange rates and interest rate differential are negatively correlated, implying a violation of uncovered interest rate parity in the data. This dissertation solves the forward premium puzzle by introducing a new generalized risk factor that consistently changes the negative slope to positive across 11 countries. In this dissertation, I conclude that, the forward premium puzzle is likely to be caused by large but infrequent shocks to the exchange spot rates. The shocks could be the market participants inability of forecasting the exchange rate movement given short-term information. Over the long run, the market participants are more likely to learn and make accurate forecasting which cause a less violation of the UIP at the long horizon. The second explanation is the carry trade holding risk. Over the long run, the carry trade unwinding happens which reduce the violation of the UIP. Finally, the empirical evidence shows that conventional theories of risk do not explain the forward premium puzzle.
