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Market Instability and Revision Error in Risk Premium

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Abstract

This paper provides a theory and evidence that the risk premium puzzle is viewed as a phenomenon pertaining to the unstable foreign exchange market. In an unstable market, revision error uncompensated by an initial risk premium accrues due to consumer expectation revision about the ex ante uncertainty of the exchange rate. The risk premium widely deviates from its initial level, depending on the frequency of the consumer expectation revision and the degree of risk aversion. Subsequent evidence shows the existence of the revision errors for the risk premium during the Asian currency crisis and the recent financial crisis periods.

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Notes

  1. See Engel (1992), Domowitz and Hakkio (1985), Hodrick and Srivastava (1986), Bekaert and Hodrick (1992), Dutton (1993) for determination of risk premium in a general equilibrium model.

  2. See Segal and Spivak (1997), and Gul (1991) for disappointment aversion function.

  3. In matching sampling dates of the forward rate with those of the spot rate, lots of information on data may be lost. See Bekaert and Hodrick (1992).When data of forward rate were not available at the end of the month, this rate was sampled the day before the end of the month. Korean data were from the Korean Bank of Financial Settlement between January 1994 to August 1996, when there were no available market data.

  4. The Phillips-Perron Zp-statistics for risk premium and the expected rate of appreciation were −4.80 and −12.83 for Japan, −4.97 and −8.98 for the U.K., −7.41 and −8.42 for Australia, −4.13 and −7.23 for Korea, −8.67 and −7.35 for Malaysia, −5.95 and −13.25 for Thailand. Its critical value is −2.86 at the 5% significance level.

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Acknowledgements

The author would like to thank the participants from the 69th International Atlantic Economic Society conference held on Prague, Czech March 26–29 2010. Many helpful and valuable comments were received from the editor and the anonymous referees in revising the paper. This research was supported from a Kyungpook national university research fund, 2009.

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  1. Department of Economics, Kyungpook National University, SanGyuk Dong 1370, Buk-Gu, Daegu, 702-701, South Korea

    Heeho Kim

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Kim, H. Market Instability and Revision Error in Risk Premium. Int Adv Econ Res 17, 169–180 (2011). https://doi.org/10.1007/s11294-011-9299-y

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