Abstract
ISK is a characteristic of existence. Attempts to avoid it explain such arrangements as insurance, limited liability firms and diversification of investment portfolios. In recent years, risk aversion and the attendant premium for risk-bearing have been used increasingly to explain a stubborn paradox in the empirical exchange rate literature: the failure of the forward exchange rate to he an unbiased predictor of the future spot exchange rate. In this article, we review recent economic analyses of the risk premium’s role in foreign exchange markets. The starting point is an explanation of covered and uncovered interest parity and their relation to the risk premium. We then turn to a discussion of empirical tests of efficiency. In particular, we examine Iwo recent papers that demonstrate the existence of the risk premium but differ in their conclusions about market efficiency: Fama 1984; and Frankel and Froot (1986(
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