Exchange Rate Predictability and the Skewness of Bid-Ask Spreads

Abstract

I find, regardless of the exchange rate series utilized, that the incorporation of conditional (predicted) skewness as an exogenous variable in ARCH models of the exchange rate process induces significant decreases in the price of exchange rate volatility risk alongside decreases in the risk that dealers will incur losses in transactions with informed traders. In out-of-sample tests, I find ARCH models that incorporate the conditional skewness factor (augmented ARCH models) have better forecast power in relation to ARCH models that exclude the conditional skewness factor (non-augmented ARCH models) only within a low risk foreign exchange market. In aggregate, empirical findings provide evidence of an inverse relation between market risk and market efficiency within the cross-section of foreign exchange markets. This inverse relation is not predicted by theories of market efficiency or theories of intertemporal risk-return trade-offs, but can be induced by market frictions within foreign exchange markets.