Abstract
In modeling the risk premium in the foreign exchange market, I assume that money and production follow a joint stochastic process with bivariate GARCH innovations. My formulation is based on Lucas' asset pricing model and implies that the risk premium in the foreign exchange market is due to time-varying volatilities in macroeconomic variables. Testing the model for three currencies shows the time-varying risk premium to be significant in explaining the deviation of the forward foreign exchange rate from the future spot rate. Diagnostic testing of the model partially supports the market efficiency hypothesis after accounting for the time-varying risk premium. (JEL F31). © 1997 Elsevier Science Ltd.
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