Three essays on the empirical analyses of foreign exchange risk premiums

Sheng-Yung Yang

doi:10.17918/00009264

While there is a general consensus that forward rates have little if any power to forecast changes in spot rates, there is less consensus on the existence of time-varying premiums in forward rates. Progress has been made toward understanding foreign exchange risk premiums as empirical research continues, but the existence of forward foreign exchange premiums remains controversial. Unlike previous research, we have chosen to construct empirical asset pricing models that directly link the risk premiums to the state variables or risk factors that are thought to be the fundamental economic determinants of forward exchange pricing. We first link the foreign exchange risk premiums to real interest rate differentials, excess national equity market return differentials, and term structure slope differentials based on the various international parity conditions. We find that variations in risk premiums are closely linked to variations in risky asset return differentials. Accordingly, based on the modern asset pricing theory, we propose a time-varying risk premium model which links the risk premiums to macroeconomic and financial uncertainty. We find that volatilities from macroeconomic uncertainty and financial markets of the exchange countries can account for the variations in risk premiums and most of the state variables are priced. In particular, one common factor has been identified, namely the US real output shocks, which affect the pricing for all foreign currencies. The implication is that a shock in the US market might produce an uncertainty, transmitting into the national currency market. Finally, to distinguish the possibly short-lived risk premium and/or market inefficiency, we use high frequency data that relates the risk premiums to relative volatility perceived in the national equity markets. In general, the result is consistent with the risk premium hypothesis where a positive speculative profit is a reward for bearing a relatively higher risk. This dissertation contributes to existing literature by offering further evidence regarding the pricing of forward foreign exchange rates and time-varying risk premiums. Issues such as peso problems, learning, irrational speculative bubbles, as well as the effect of transaction costs will definitely play some roles in explaining forward rate determination and are left to future research.

Three essays on the empirical analyses of foreign exchange risk premiums

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Three essays on the empirical analyses of foreign exchange risk premiums

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