Abstract
Empirical investigation into the nature and significance of exchange rate risk premiums has evolved from naive studies of the time-series properties of spot and forward exchange rates to sophisticated tests of agents’ first-order conditions for expected utility maximization. Modern empirical work recognizes that any test concerning the behavior of exchange rate risk premiums is necessarily a joint hypothesis test of an equilibrium model of exchange risk and return, an assumption about expectations formation, and a set of auxiliary statistical assumptions under which formal inference proceeds. The evolution in theoretical and econometric sophistication over the past 15 years is the subject of this review. Fortunately, the task of reviewing the risk premium literature has been greatly simplified by the recent publication of a number of related survey papers.1 In particular, this review makes considerable use of Hodrick’s (1987) recent monograph, The Empirical Evidence on the Efficiency of Forward and Future Foreign Exchange Markets.
Access this chapter
Tax calculation will be finalised at checkout
Purchases are for personal use only
Preview
Unable to display preview. Download preview PDF.
References
Adler, M. and B. Dumas (1983), “International Portfolio Choice and Corporation Finance: A Survey,” Journal of Finance, 38, 925–984.
Akerlof, G. and J. Yellen (1985), “Can Small Deviations from Rationality Make Significant Differences to Economic Equilibria?” American Economic Review, 75, 708–720.
Artus, J. (1976), “Exchange Rate Stability and Managed Floating: The Experience of the Federal Republic of Germany,” International Monetary Fund Staff Papers, 23, 312–333.
Baillie, R., R. Lippens, and P. McMahon (1983), “Testing Rational Expectations and Efficiency in the Foreign Exchange Market,” Econometrica, 51, 553–564.
Bilson, J. (1981), “The Speculative-Efficiency Hypothesis,” Journal of Business, 55, 435–451.
Board of Governors of the Federal Reserve System, Staff Studies Nos. 126–135.
Bollerslev, T., R. Engle, and J. Wooldridge (1985), “A Capital Asset Pricing Model with Time Varying Covariances,” University of California, San Diego, mimeo.
Branson, W. and D. Henderson (1985), “The Specification and Influence of Asset Markets,” in R. Jones and P. Kenen (Eds.), Handbook of International Economics, Vol. 2, Elsevier Science, Amsterdam, pp. 749–804.
Branson, W., Halttunen, and P. Masson (1977), “Exchange Rates in the Short Run: The Dollar-Deutschemark Rate,” European Economic Review, 10, 303–324.
Branson, W., Halttunen, and P. Masson (1979), “Exchange Rates in the Short Run: Some Further Results,” European Economic Review, 12, 395–402.
Caramazza, F., K. Clinton, A. Cote, and D. Longworth (1986), “International Capital Mobility and Asset Substitutability: Some Theory and Evidence on Recent Structural Changes,” Bank of Canada Technical Reports No. 44.
Cornell, W. and J. Dietrich (1978), “The Efficiency of the Market for Foreign Exchange Under Floating Exchange Rate,” Review of Economics and Statistics, 60, 111–120.
Cox, J., J. Ingersol, and S. Ross (1985), “An Intertemporal General Equilibrium Model of Asset Prices,” Econometrica 53; 363–384.
Cumby, R. (1986), “Is It Risk? Explaining Deviations from Uncovered Interest Parity,” New York University mimeo.
Cumby, R. and M. Obstfeld (1984), “International Interest-Rate and Price-Level Linkages under Flexible Exchange Rate: A Review of Recent Evidence,” in J. Bilson and R. Marston (Eds.), Exchange Rates: Theory and Practice, University of Chicago Press, Chicago.
Danker, D., R. Haas, D. Henderson, S. Symansky, and R. Tryon (1985). “Small Empirical Models of Exchange Market Intervention: Applications to Germany, Japan, and Canada,” Board of Governors of the Federal Reserve System Staff Studies No. 135.
DeBondt, W. and R. Thaler (1985), “Does the Stock Market Overreact?” Journal of Finance, 40, 793–805.
Domowitz, I. and C. Hakkio (1985), “Conditional Variance and the Risk Premium in the Foreign Exchange Market,” Journal of International Economics, 19, 47–66.
Dooley, M. and P. Isard (1982), “A Portfolio-Balance Rational Expectations Model of the Dollar-Mark Exchange Rate,” Journal of International Economics, 12, 257–276.
Dooley, M. and J. Shafer (1976), “Analysis of Short-Run Exchange Rate Behavior, March 1973 to September 1975,” Board of Governors of the Federal Reserve International Finance Discussion Paper No. 76.
Dooley, M. and J. Shafer (1983), “Analysis of Short-Run Exchange Rate Behavior, March 1973 to November 1981,” in D. Bigman and T. Taya (Eds.), Exchange Rate and Trade Instability, Ballinger.
Dornbusch, R. (1983), “Exchange Rate Risk and the Macroeconomics of Exchange Rate Determination,” in R. Hawkins, R. Levich, and C. Wihlborg (Eds.), The Internationalization of Financial Markets and National Economic Policy, JAI Press.
Engel, C. (1984), “Testing for the Absence of Expected Real Profits from Forward Market Speculation,” Journal of International Economics, 17, 299–308.
Engle, R. (1982), “Autoregressive Conditional Heteroskedasticity with Estimates of the Variance of U.K. Inflation.” Econometrica, 50, 987–1008.
Engle, R. and C. Granger (1987), “Cointegration and Error Correction: Representation, Estimation and Testing,” Econometrica, 55, 251–276.
Evans, G. (1986), “A Test for Speculative Bubbles and the Sterling-Dollar Exchange Rate: 1981–84,” American Economic Review, 76, 621–636.
Fama, E. (1984), “Forward and Spot Exchange Rates,” Journal of Monetary Economics, 14, 319–388.
Fama, E. and A. Farber (1979), “Money, Bonds and Foreign Exchange,” The American Economic Review, 69, 639–349.
Federal Reserve Bulletin (November 1983).
Flavin, M. (1983), “Excess Volatility in the Financial Markets: A Reassessment of the Empirical Evidence,” Journal of Political Economy, 91, 929–956.
Flood, R. and P. Garber (1980), “Market Fundamentals versus Price-Level Bubbles: The First Tests,” Journal of Political Economy, 88, 745–770.
Flood, R. and P. Garber (1983), “A Model of Stochastic Process Switching,” Econometrica, 51, 537–552.
Frankel, J. (1979a), “The Diversifiability of Exchange Risk,” Journal of International Economics, 9, 379–393.
Frankel, J. (1979b), “A Test of the Existence of the Risk Premium in the Foreign Exchange Market versus the Hypothesis of Perfect Substitutability,” Board of Governors of the Federal Reserve International Finance Discussion Paper No. 149.
Frankel, J. (1982), “In Search of the Exchange Risk Premium: A Six-Currency Test Assuming Mean-Variance Optimization,” Journal of International Money and Finance, 1, 255–274.
Frankel, J. (1983), “Estimation of Portfolio-Balance Functions That Are Mean-Variance Optimizing: The Mark and the Dollar,” European Economic Review, 23, 315–327.
Frankel, J. (1986), “The Implications of Mean-Variance Optimization for Four Questions in International Macroeconomics,” Journal of International Money and Finance, 5, (Suppl.), s53-s75.
Frankel, J. and K. Froot (1985), “Using Survey Data to Test Standard Propositions Regarding Exchange Rate Expectations,” NBER working paper No. 1672.
Frankel, J. and K. Froot (1986a), “Interpreting Tests of Forward Discount Bias Using Survey Data on Exchange Rate Expectations,” University of California, Berkeley, mimeo.
Frankel, J. and K. Froot (1986b), “The Dollar as a Speculative Bubble: A Tale of Chartists and Fundamentalists,” University of California, Berkeley, mimeo.
French, K. and R. Roll (1984), “Stock Return Variances: The Arrival of Information and Reaction of Traders,” University of California, Los Angeles, mimeo.
Frenkel, J. and A. Razin (1980), “Stochastic Prices and Tests of Efficiency of Foreign Exchange Markets,” Economic Letters, 6, 165–170.
Friedmen, D. and S. Vandersteel (1982), “Short Run Fluctuations in Foreign Exchange Rates: Evidence from the Data, 1973–79,” Journal of International Economics, 13, 171–186.
Froot, K. (1986), “Currency Values in a Continuous Time Capital Asset Pricing Model Driven by Asset Supplies,” Ph.D. dissertation, University of California, Berkeley.
Geweke, J. and E. Feige (1979), “Some Joint Tests of the Efficiency of the Markets for Forward Foreign Exchange,” Review of Economics and Statistics, 61, 334–341.
Giddy, I. and M. Dufey (1975), “The Random Behavior of Flexible Exchange Rates,” Journal of International Business Studies, 6, 1–32.
Giovannini, A. and P. Jorion (1986), “Interest Rates and Risk Premia in the Stock Market and in the Foreign Exchange Market,” Columbia University mimeo.
Grauer, F., R. Litzenberger, and R. Stehle (1976), “Sharing Rules and Equilibrium in an International Capital Market with Uncertainty,” Journal of Financial Economics, 3, 233–256.
Hakkio, G. (1981), “The Term Structure of the Forward Premium,” Journal of Monetary Economics, 8, 41–58.
Hansen L. and R. Hodrick (1980), “Forward Exchange Rates as Optimal Predictors of Future Spot Rates: An Econometric Analysis,” Journal of Political Economy, 88, 828–853.
Hansen L. and R. Hodrick (1983), “Risk Averse Speculation in the Forward Foreign Exchange Market: An Econometric Analysis of Linear Models,” in J. Frenkel (Ed.), Exchange Rates and International Macroeconomics, University of Chicago Press, Chicago.
Hodrick, R. (1981), “International Asset Pricing with Time-Varying Risk Premia,” Journal of International Economics, 11, 573–577.
Hodrick, R. (1987), The Empirical Evidence on the Efficiency of Forward and Future Foreign Exchange Markets, Harwood Academic, Chur, Switzerland.
Hodrick, R. and S. Srivastava (1984), “An Investigation of Risk and Return in Forward Foreign Exchange,” Journal of International Money and Finance, 3, 5–29.
Hodrick, R. and S. Srivastava (1986), “The Covariation of Risk Premiums and Expected Future Spot Exchange Rates,” Journal of International Money and Finance, 5 (Suppl.) s5-s21.
Hsieh, D. (1984), “Tests of Rational Expectations and No Risk Premium in Forward Exchange Markets,” Journal of International Economics, 17, 173–184.
Huang, R. (1981), “The Monetary Approach to Exchange Rates in an Efficient Foreign Exchange Market: Tests Based on Volatility,” Journal of Finance, 36, 31–41.
Isard, P. (1986), “The Empirical Modeling of Exchange Rates: An Assessment of Alternative Approaches,” International Monetary Fund mimeo.
Kleidon, A. (1986a), “Bias in Small Sample Tests of Stock Price Rationality,” Journal of Business, forthcoming.
Kleidon, A.(1986b), “Variance Bounds Tests and Stock Price Valuation Models,” Journal of Political Economy, forthcoming.
Kouri, P. (1977), “International Investment and Interest Rate Linkages under Flexible Exchange Rates,” in R. Aliber (Ed.), The Political Economy of Monetary Reform, Macmillan, New York.
Kouri, P. and M. Porter (1977), “International Capital Flows and Portfolio Equilibrium,” Journal of Political Economy, 82, 443–467.
Krasker, W. (1980), “The ‘Peso Problem’ in Testing the Efficiency of Forward Exchange Markets,” Journal of Monetary Economics, 6, 269–276.
Krugman, P. (1981), “Consumption Preferences, Asset Demands and Distribution Effects in International Financial Markets,” NBER working paper No. 651.
LeRoy, S. and R. Porter (1981), “The Present Value Relation and Implied Variance Bounds,” Econometrica, 49, 555–574.
Levich, R. (1979), “On the Efficiency of Markets for Foreign Exchange,” in R. Dornbusch and J. Frenkel (Eds.), International Ecomomic Policy: Theory and Evidence, Johns Hopkins Press, Baltimore.
Levich, R. (1985), “Empirical Studies of Exchange Rates: Price Behavior, Rate Determination and Market Efficiency,” in R. Jones and P. Kenen (Eds.), Handbook of International Economics, Vol. 2, Elsevier Science Amsterdam.
Logue, D., R. Sweeney, and T. Willett (1978), “The Speculative Behavior of Foreign Exchange Rates during the Current Float,” Journal of Business Research, 6, 150–174.
Lucas, R. (1976), “Econometric Policy Evaluation: A Critique,” in K. Brunner and A. Meltzer (Eds.), The Philips Curve and Labor Markets, Carnegie-Rochester Conference Series on Public No. 1, North-Holland, Amsterdam, pp. 19–46.
Lucas, R. (1982), “Interest Rates and Currency Prices in a Two-Country World,” Journal of Monetary Economics, 12, 55–93.
MacKinnon, J. and H. White (1985), “Some Heteroskedasticity Consistent Covariance Matrix Estimators with Improved Finite Sample Properties,” Queens University mimeo.
Mattey, J. and R. Meese (1986), “Empirical Assessment of Present Value Relations,” Econometric Reviews, 5, 171–234.
Meese, R. (1986), “Testing for Bubbles in Exchange Markets: A Case of Sparkling Rates?” Journal of Political Economy, 94, 345–373.
Meese, R. and K. Rogoff (1983a), “Empirical Exchange Rate Models of the Seventies: Do They Fit Out-of-Sample?” Journal of International Economics, 14, 3–24.
Lucas, R. (1983b), “The Out-of-Sample Failure of Empirical Exchange Rate Models: Sampling Error or Misspecification?” in J. Frenkel (Ed.), Exchange Rates and International Macroeconomics, University of Chicago Press, Chicago.
Meese, R. and K. Singleton (1982), “On Unit Roots and the Empirical Modeling of Exchange Rates,” Journal of Finance, 37, 1029–1035
Meese, R. and K. Singleton (1983), “Rational Expectations and the Volatility of Floating Exchange Rates,” International Economic Review, 24, 721–733.
Mussa, M. (1979), “Empirical Regularities in the Behavior of Exchange Rates and Theories of the Foreign Exchange Market,” Carnegie-Rochester Series on Public Policy, 11, 9–57.
Mussa, M. (1981), “The Role of Official Intervention,” Group of Thirty Occasional Papers 6.
Obstfeld, M. (1983), “Exchange Rates, Inflation and the Sterilization Problem: Germany 1975–1981,” European Economic Review, 21, 161–189.
Obstfeld, M. and K. Rogoff (1983), “Speculative Hyperinflations in Maximizing Models: Can We Rule Them Out?” Journal of Political Economy, 91, 675–687.
Obstfeld, M. and K. Rogoff (1986), “Ruling Out Divergent Speculative Bubbles,” Journal of Monetary Economics, 349–362.
Obstfeld, M. and A. Stockman (1985), “Exchange Rate Dynamics,” in R. Jones and P. Kenen (Eds.), Handbook of International Economics, Vol. 2, Elsevier Science, Amsterdam.
Poole, W. (1967), “Speculative Prices as Random Walks: An Analysis of Ten Time Series of Flexible Exchange Rates,” Southern Economic Journal, 33, 468–478.
Richard, S. and M. Sundaresan (1981), “A Continuous Time Equilibrium Model of Forward Prices and Future Prices in a Multigood Economy,” Journal of Financial Economics, 9, 347–372.
Rogoff, K. (1979), “Essays on Expectations and Exchange Rate Volatility,” Ph.D. dissertation, Massachusettes Institute of Technology, Cambridge.
Roper, D. (1975), “The Role of Expected Value Analysis for Speculative Decisions in the Foreign Currency Market,” Quarterly Journal of Economics, 89, 157–169.
Shiller, R. (1981a), “Do Stock Prices Move Too Much to Be Justified by Subsequent Changes in Dividends?” American Economic Review, 71, 421–436.
Shiller, R. (1981b), “The Use of Volatility Measures in Assessing Market Efficiency,” Journal of Finance, 36, 291–311.
Singleton, K. (1980), “Expectations Models of the Term Structure and Implied Variance Bounds,” Journal of Political Economy, 88, 1159–1176.
Solnik, B. (1974), “An Equilibrium Model of the International Capital Market,” Journal of Economic Theory, 8, 500–524.
Stock, J. (1987), “Asymptotic Properties of Least Squares Estimators of Cointegrated Vectors,” Econometrica, 55, 1035–1056.
Stockman, A. (1978), “Risk, Information and Forward Exchange Rates,” in J. Frenkel and H. Johnson (Eds.), The Economics of Exchange Rates, Addison-Wesley, Reading, MA.
Stockman, A. (1979), “Monetary Control and Sterilization under Pegged Exchange Rates,” University of Rochester mimeo.
Stulz, R. (1981), “A Model of International Asset Pricing,” Journal of Financial Economics, 383–406.
Stulz, R. (1982), “The forward Rate and Macroeconomics,” Journal of Monetary Economics, 12, 285–299.
Svensson, L. (1985), “Currency Prices, Terms of Trade and Interest Rates: A General Equilibrium Asset-Pricing Cash-in-Advance Approach,” Journal of International Economics, 15, 17–41.
Sweeney, R. (1986a), “Beating the Foreign Exchange Market,” Journal of Finance, 41, 163–182.
Sweeney, R. (1986b), “Risk Premia in Forward Exchange Rates: Systematic or Non-systematic?” Claremont Graduate School mimeo.
Sweeney, R. and E. Lee (1985), “Trading Strategies in Forward Exchange Markets,” Claremont Graduate School mimeo.
Tryon, R. (1979), “Testing for Rational Expectations in Foreign Exchange Markets,” Federal Reserve Board International Finance Discussion Paper No. 139.
West, K. (1985), “A Standard Monetary Model and the Variability of the Deutsemark-Dollar Exchange Rate,” Princeton University mimeo.
Woo, W. (1984), “Speculative Bubbles in the Foreign Exchange Markets,” Brooking Discussion Paper in International Economics.
Editor information
Editors and Affiliations
Rights and permissions
Copyright information
© 1989 Kluwer Academic Publishers
About this chapter
Cite this chapter
Meese, R. (1989). Empirical Assessment of Foreign Currency Risk Premiums. In: Stone, C.C. (eds) Financial Risk: Theory, Evidence and Implications. Springer, Dordrecht. https://doi.org/10.1007/978-94-009-2665-3_9
Download citation
DOI: https://doi.org/10.1007/978-94-009-2665-3_9
Publisher Name: Springer, Dordrecht
Print ISBN: 978-94-010-7701-9
Online ISBN: 978-94-009-2665-3
eBook Packages: Springer Book Archive