Time-varying risk premia in the foreign currency futures basis

Journal of International Economics, 1993

This paper uses currency futures prices to test the joint null hypotheses of rational expectations and absence of a time-varying risk premium in the foreign exchange market. We find no linear predictability in the logarithm of futures price changes, either using its own past or past interest differentials. Also we establish that there is no non-linear predictability in log price changes, conditioning on its own past, or past interest rate differentials. Thus, if a time-varying risk premium exists in currency futures market, it is not related to its own past or past interest rate differentials.

Journal of International Economics, 1987

International Journal of Risk Assessment and Management, 2003

This paper investigates the relationship between the excess returns of foreign exchanges and the conditional volatility of domestic and foreign equity markets, based on a wide range of foreign currency market data. Utilising a VAR-GARCH-in-mean process to generate conditional variances, we find evidence to support the time varying, risk-premium hypothesis. Moreover, our evidence shows that the volatility evolution of stock returns displays not only a clustering phenomenon, but also a significant spillover effect. Given the fact that the correlation structure across markets is significant and time varying, investors and portfolio managers should continually assess this information and rebalance their portfolios over time to achieve optimal diversification.

Studies in Computational Finance, 2000

There is a huge literature on the existence of risk premia in the foreign exchange market and its influence in explaining the divergence between the forward exchange rate and the subsequently realised spot exchange rate. In this paper, we seek to model directly the risk premium as a mean-reverting diffusion process. This is done by making use of the spot-forward price relationship and assuming a geometric diffusion process for the spot exchange rate. We are able to obtain a stochastic differential equation system for the spot exchange rate, the forward exchange rate and the risk premium which we estimate using Kalman filtering techniques.

Global Finance Journal, 2008

Japanese yen currency dynamics are investigated in spot and futures markets. Maturity is proposed as a proxy for the time-varying risk premium. As the maturity of a yen futures contract nears, there is less uncertainty implying a small absolute risk premium. A longer maturity is associated with uncertainty about the economy, the underlying currency, and the contract; and implies a high risk premium. Models that include maturity in addition to the futures-spot basis as explanatory variables exhibit better empirical performance in explaining futures returns and spot returns. The results are robust to different sample periods, forecast horizons, and estimation techniques.

Journal of International Money and Finance, 1990

Assuming that daily spot exchange rates follow a martingale process. we derive the implied time series process for the vector of 30-day forward rate forecast errors from using weekly data. The conditional second moment matrix of this vector is modeled as a multivariate generalized ARCH process. The estimated model is used to test the hypothesis that the risk premium is a linear function of the conditional variances and covariances as suggested by the standard asset pricing theory literature. Little support is found for this theory; instead lagged changes in the forward rate appear to be correlated with the 'risk premium.' * We wish to thank an anonymous referee, Ian Domowitz, Robert Hodrick, and Mark Watson for helpful conversations and suggestions. Paula Nielsen and Lori Austin did an excellent job keyboarding a difficult manuscript. 0261-5606/90/03/0309-16 0 1990 Butterworth-Heinemann Ltd

Journal of International Money and Finance, 1986

Fama (1984) analyzed the variability and the covariation of risk premiums and expected. rates of depreciation. We employ three statistical techniques that do not suffer from a potential bias in Fama's analysis, but we nevertheless confirm his findings. In contrast to his interpretation the results are not necessarily at variance with the 'predictions of a theoretical model of the risk premium. Increases in expected rates of depreciation of the dollar relative to five foreign currencies are positively correlated with increases in the expected profitability of purchasing these currencies in the forward market, and risk premiums have larger variances than expected rates of depreciation.

Journal of International Financial Markets, Institutions and Money, 2007

This paper explores the usefulness of currency futures-spot basis in predicting spot rate changes and currency futures returns. We conjecture that the currency risk premium may be an important component of the basis for long-maturity futures contracts, but may not be so for short-maturities. Thus, the basis of long-maturity contracts cannot predict the spot rate changes between now and maturity, rejecting uncovered interest rate parity (UIP), but can predict currency futures returns, which are solely determined by the risk premium. Conversely, the basis of the short-maturity contracts can predict the spot rate changes between now and maturity, validating the UIP, but cannot predict currency futures returns. Empirical tests support these conjectures for the Japanese, British, Swiss, and German currencies over the last two decades. The results are also consistent with Longstaff [Longstaff, F., 2000. The term structure of very short-term rates: new evidence for the Expectation Hypothesis. Journal of Financial Economics 58, 397-415], who shows that the Expectations Hypothesis holds at the very short end of the term structure of interest rates.

International Journal of Financial Research, 2014

In this paper we reconsider the Fama (1984)'s seminal paper and we make extensions. We take into account for ARMA dynamics and ARCH-M effects in exchange rates and we introduce in equation regressions a proxy for the liquidity. We find out that the differenced relative bid-ask spread is a significant determinant of forward risk premia. In addition we evidence the outperformance of the multimarket hypothesis vs the single market hypothesis and the existence of common factors between forward risk premia in the EUR/USD, EUR/GBP and EUR/JPY forward exchange rates.

Economics Series, 2001

Das Institut für Höhere Studien (IHS) wurde im Jahr 1963 von zwei prominenten Exilösterreicherndem Soziologen Paul F. Lazarsfeld und dem Ökonomen Oskar Morgenstern -mit Hilfe der Ford-Stiftung, des Österreichischen Bundesministeriums für Unterricht und der Stadt Wien gegründet und ist somit die erste nachuniversitäre Lehr-und Forschungsstätte für die Sozial-und Wirtschaftswissenschaften in Österreich. Die Reihe Ökonomie bietet Einblick in die Forschungsarbeit der Abteilung für Ökonomie und Finanzwirtschaft und verfolgt das Ziel, abteilungsinterne Diskussionsbeiträge einer breiteren fachinternen Öffentlichkeit zugänglich zu machen. Die inhaltliche Verantwortung für die veröffentlichten Beiträge liegt bei den Autoren und Autorinnen.

Journal of Applied Econometrics, 1991

In this paper a VAR model is employed to construct a measure of the conditional expectations of the future yen/dollar spot rate. This measure allows us to examine the dynamics of an ex-ante time-series for the risk premium in the market. The VAR model produces 'better' forecasts than the survey responses for turbulent periods such as 1981-1982 and 1984-1985. The VAR-generated expectations are then used to construct a risk premium time-series. This risk premium ieerie series seems to be more reliable than the ones obtained using either survey data on expectations of the future spot exchange rate or the ex-post realized spot exchange rate. Tests on the risk premium series suggest that a risk premium was present, but that it was virtually constant throughout the sample. The conditional variance of the risk premium changed over time, but its unconditional distribution seemed stable across subsamples. Despite these features, the volatility of the series was substantial and varied considerably throughout the sample. 1. INTRODUCTION The size and the variability of the risk premium in foreign exchange markets are of crucial importance in analysing issues concerning the efficiency of thy ese markets. Several authors (for example, Frankel, 1986; Frankel and Meese, 1987) have argued that, theoretically, the risk premium should be small and approximately constant. The experience of the 1980s in several foreign exchange markets indicates that the ex-post bias of the forward rate is very large and volatile. Since the ex-post forward bias is the sum of a forecast error and of a risk premium, many researchers find it hard to attribute the empirical features of the forward bias to a risk premium, and conclude that there are persistent patterns in the forecast errors made by agents. Some have interpreterd this evidence as an indication that a 'peso problem' may have occurred in the 1980s (see e.g. Krugman, 1987). Others have used this result to question the rationality of investors' expectations (see e.g. Frankel and Froot, 1987). Since the risk premium is unobservable, a crucial step in investigating the efficient market hypothesis is the construction of (a proxy for) the risk premium. The empirical evidence on the properties of risk premium proxies is somewhat contradictory.

2007

Using financial experts' Yen/USD exchange rate expectations provided by Consensus Forecasts surveys, this paper aims to model the 3 and 12-month ahead ex-ante risk premia, measured as the difference between the expected and forward exchange rates. The condition of predictability of returns implies that the variance of the rate of change in exchange rate is horizon-dependent and this is a sufficient condition for agents not to require at any time a risk premium but a set of premia scaled by the time horizon of the investment. Moreover, using a two-step portfolio decision making process framework, we show that each premium depends on the net market position related to the maturity of the asset considered. Since the time-varying real net market positions are unobservable, they have been estimated through a state space model using the Kalman filter methodology. We find that a two-country portfolio asset pricing model explains satisfactorily both the common and the specific timepatterns of the 3-and 12-month ex-ante premia.

Journal of Futures Markets, 1987

IMF Working Papers, 2006

This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate. Large fundamental imbalances persist in the global economy, with potential exchange rate implications. This paper assesses whether exchange rate risk is priced across G-7 stock markets. Given the multitude of hedging instruments available, theory suggests that stock market investors should not be compensated for currency risk. However, data covering 33 industry portfolios across seven major stock markets suggest that not only is exchange rate risk priced in many markets, but that it is time-varying and sensitive to currency-specific shocks. With stock market investors typically exhibiting "home bias," this suggests that investors are using equity asset proxies to hedge the exchange rate risks to consumption.

European Financial Management, 1997

International asset pricing requires to take into account currency risk. Equilibrium models of the international capital market show that risk premia should be associated with currency risks. This is supported by empirical evidence. This paper reviews the existing theoretical and empirical literature and discusses their practical implications.