Risk premia on foreign exchange: a direct approach

Abstract

This paper derives an explicit, direct model of the foreign exchange risk premium as an observable variable and uses it to test the time-variation and stationarity of foreign exchange risk premiums. It also examines the significance and accuracy of the forward market forecast error in predicting the risk premium. Assuming that returns in the foreign exchange market can be described by a diffusion-type stochastic process, it shows that the risk premium on foreign exchange is a weighted average (weighted by a finite time interval) of the forward premium and the exchange rate risk-adjusted excess return to holding foreign exchange. We find that there exists a long-run equilibrium relationship between the forward premium and the risk-adjusted excess return in a cointegrated system. The Johansen (Econometrica 59 (1991) 1551) procedure for cointegration tests confirms that risk premiums are stationary and time-varying. The forward market forecast error appears to be a poor predictor for the risk premium on foreign exchange.