Excess Returns in a Small Open Economy*

This paper presents detailed analysis of a very unusual event —a recent six‐year period during which big excess returns were earned on the short‐term interest‐bearing assets of a small open economy: Australia. A risk premium does not explain the excess return. Rather than requiring a risk premium, market participants continually expected significant real depreciation of the Australian dollar, despite the fact that on average it appreciated in real terms. Our results may be a consequence of the foreign exchange market only gradually learning about the changed nature of the world capital market in the 1980s.