Forward Speculation, Excess Returns, and Exchange Rate Variability: The Role of Risk Premiums

The paper reconsiders the unbiasedness hypothesis in the foreign exchange market. Within the context of a conventional model of exchange rates, risk premium shocks are constrained to have no permanent effects on the spot rate. Using monthly data from the post-floating period, the paper estimates risk premiums for the dollar rates of the yen, mark, and pound. Risk premium innovations seem to explain a modest proportion of short-term variability of exchange rate changes and excess returns. However, risk premiums may explain serial correlations in excess returns.     

Price transmission,foreign exchange rate risks and global diversification of ADRs

The purposes of this article are to reinvestigate how returns of major American depository receipts (ADRs) from different countries are related to the underlying stock returns and to identify the determinants of ADR risk premiums. We use different types of error-correcting terms in vector error correction models to examine information flows between ADRs and the underlying foreign stocks. General method of moments estimation of conditional international asset pricing model of Dumas and Solnik (1995 Dumas, B and Solnik, B. 1995. The world price of foreign exchange risk. Journal of Finance, 50: 445–79. [Crossref], [Web of Science ®] , [Google Scholar]) is applied to investigate ADR return premiums. We find that stock returns are more affected by disequilibrium between ADR and stock prices in an inefficient way. For US investors, foreign exchange rate risk premiums and world market risk premium (beyond US index) are priced in ADRs returns ex ante. Surprisingly, it is shown that the exchange rate of New Taiwan dollar and the interest rates of Brazil and Taiwan play important roles in determining ADR risk premiums across countries.     

Forward-premium puzzle: is it time to abandon the usual regression?

The forward premium puzzle is usually evidenced by the rejection of the null hypothesis in the uncovered interest parity (UIP) regression. Because this parity need only hold in a risk-neutral world, a risk adjustment term is missing from the equation if speculation in foreign exchange markets is risky. We deal with this issue following the literature which assumes that discounted returns on foreign government bonds are log-normal, so we can linearize the Euler pricing equations (in level) and obtain a modified UIP system for which the risk adjustment term is obtained by applying to the pricing kernel-based relations a generalized autoregressive conditional heteroscedasticity-in-mean model. However, here we innovate by adopting a methodology which differs from all these related works. We construct and use a stochastic discount factor that does not depend on a specific model, by residing in the space of returns which we extract from the data by simply imposing the orthogonality restrictions represented by the Euler equations. So, we devise a purely statistical pricing kernel that performs well in in-sample level equations. Somewhat disappointingly, the risk premium inclusion in the conventional regression changes neither the significance nor the magnitude of the forecasting power of the forward premium for most currencies we study. The contrasting performance of the tests in level and in logs suggests that linearization may be to blame.     

Aggregate and disaggregate measures of the foreign exchange risk premium

Using a disaggregate survey database, this paper reexamines the issue of the existence of a time-varying risk premia in three foreign exchange markets. Previous research on this topic has utilised a consensus measure of the risk premium, based on the rational expectations assumption, and is not supportive of the existence of such a premium. In contrast, this paper reports compelling evidence in favour of time-varying risk premia for the British pound (BP), German mark (DM), and Japanese yen (JY) exchange rates. In particular, we demonstrate that consensus measures of the risk premium mask the existence of risk because of the importance of heterogeneous expectations.     

Expectations and the Black Market Premium

The purpose of this paper is to gain a better understanding of the black market premium—the percentage differential between the black market and the official exchange rate. Tests are used to see whether the black market premium responds to variations in expectations about the official exchange rate in Argentina, Brazil, Colombia, and Mexico. Expectations of devaluation do cause movements in the black market premium for Argentina, Brazil, and Mexico but this behavior is not observed for Colombia. Colombian economic agents seem less sensitive to expected returns. This perhaps explains the relatively flat black market premium series observed for Colombia.     

A Theory of Exchange Rates and the Term Structure of Interest Rates

This paper defines the concepts of indirect and direct risk premium effects and analyzes their properties in an exchange rate model. In the model, these effects are endogenously determined in a rational expectations equilibrium. For the effect of an interest rate shock, they have the opposite signs and the indirect risk premium effect can dominate the direct risk premium effect under reasonable parameters. This means that domestic short‐term bonds and foreign bonds are complements in the model even though domestic long‐term bonds and foreign bonds are substitutes. This model, focusing on the indirect risk premium effect and on the term structure of interest rates, can be combined with a small sample bias approach to explain stylized facts about the forward premium anomaly, which is found for short‐term interest rates, but not for long‐term interest rates.     

Nonlinear adjustment in the forward premium: evidence from a threshold unit root test

This paper considers testing the mean reversion of the forward premium in a nonlinear framework. In contrast to previous studies, we consider a novel approach that allows for testing for a unit root in the forward premium while explicitly allowing for nonlinearity in the data. Within this approach, we employ bootstrap methods based on threshold autoregressive (TAR) models to investigate whether the 1- and 3-month forward premia for six industrialized countries are mean-reverting. Overall, we are able to reject the null hypotheses of linearity and nonstationarity indicating nonlinear mean reversion. Furthermore, large deviations of the forward premium from its equilibrium band are found to have faster speed of mean reversion than small deviations, which are strongly persistent. In all, the results support the view that the forward premium exhibits mean reversion, but in a special manner not captured by the usual linear tests. Finally, the results have important implications for foreign exchange market efficiency under risk aversion.     

On the term structure of the foreign exchange rates and market efficiency

The efficiency hypothesis of the foreign exchange market is examined by considering the term structure of foreign exchange rates jointly with that of interest rates in the context of interest rate parity principle. The Canadian–U.S. data are found to be consistent with the hypothesis of the market efficiency and a constant exchange risk premium.     

Market Instability and Revision Error in Risk Premium

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.     

Asset return dynamics and the FX risk premium in a decentralized dealer market

The paper proposes a continuous time model of an FX market organized as a multiple dealership. The dealers have costly access to best available quotes. They interpret signals from the joint dealer-customer order flow and decide upon their own quotes and trades in the inter-dealer market. Each dealer uses the observed order flow to improve the subjective estimates of relevant aggregate variables, which are the sources of uncertainty. The risk factors are returns on domestic and foreign assets and the size of the cross-border dealer transactions in the FX market. These uncertainties have diffusion form and are dealt with according to the principles of portfolio optimization in continuous time. The model is used to explain the country, or risk, premium in the uncovered national return parity equation for the exchange rate. The two country premium terms that I identify in excess of the usual covariance term (consequence of the “Jensen inequality effect”) are: the dealer heterogeneity-induced inter-dealer market order flow component and the dealer Bayesian learning component. As a result, an “order flow-adjusted total return parity” formula links the excess FX return to both the “fundamental” factors represented by the differential of the national asset returns, and the microstructural factors represented by heterogeneous dealer knowledge of the aggregate order flow and the fundamentals.     

Understanding Exchange Rate Movements during the 2008 Financial Crisis

During the 2008 financial crisis, many advanced economies, whose banking systems suffered significant capital losses, experienced large and rapid exchange rate depreciations followed by prolonged and gradual appreciation in subsequent periods. In order to understand one possible explanation of these observed exchange rate movements, we develop a simple model of a highly leveraged banking sector in which banks obtain part of their funding from abroad. A fall in bank net worth leads to foreign lenders demanding a higher risk premium on credit supplied to domestic banks. This higher risk premium can be met if the exchange rate experiences an appreciation along the adjustment path, since this raises the value of the bank's earnings in terms of the foreign currency for every period that the foreign risk premium is elevated. In order for the exchange rate to appreciate by a large amount along the adjustment path, it must initially become undervalued – relative to its long-run level – so that in equilibrium the market is willing to bid up its value in subsequent periods. This thus gives rise to the large initial depreciation of the exchange rate followed by its prolonged and gradual appreciation.     

Another Look at the Equity Risk Premium Puzzle

The model of Mehra and Prescott (1985, J. Econometrics, 22, 145–161) implies that reasonable coefficients of risk‐aversion of economic agents cannot explain the equity risk premium generated by financial markets. This discrepancy is hitherto regarded as a major financial puzzle. We propose an alternative model to explain the equity premium. For normally distributed returns and for returns far away from normality (but still light tailed), realistic equity risk premia do not imply puzzlingly high risk aversions. Following our approach, the ‘equity premium puzzle’ does not exist. We also consider fat‐tailed return distributions and show that Pareto tails are incompatible with constant relative risk aversion.     

The Impact of Regret on Exports

We examine optimal production and export decisions of a firm facing exchange rate uncertainty, where the firm's management is not only risk averse but also regret averse, i.e., is characterized by a utility function that includes disutility from having chosen ex post suboptimal alternatives. Experimental and empirical results support the view that managers tend to be regret averse. Under regret aversion a negative risk premium need not preclude the firm from exporting which would be the case if the firm were only risk averse. Exporting creates an implicit hedge against the possibility of regret when the realized spot exchange rate turns out to be high. The regret‐averse firm as such has a greater ex ante incentive to export than the purely risk averse firm. Finally, we use a two‐state example to illustrate that the firm optimally exports more (less) to the foreign country than in the case of pure risk aversion if the low (high) spot exchange rate is more likely to prevail. Regret aversion as such plays a crucial role in determining the firm's optimal allocation between domestic sales and foreign exports.     

Resolving the unbiasedness and forward premium puzzles

There are two unresolved puzzles in the foreign exchange literature. The unbiasedness puzzle – the finding of a marked difference in the conclusion about the forward rate unbiasedness hypothesis depending on whether the hypothesis is tested using the forward rate equation or forward premium equation, and the forward premium puzzle – the fact that more often than not the forward premium incorrectly predicts the direction of the subsequent change in the spot rate. This paper resolves both puzzles.     

Asset pricing and downside risk in the Australian share market

As downside risk has been identified as a separate risk exposure to investors, we investigate whether downside beta and co-skewness exposure impact on the return to investors in Australian equities. Although considered as a developed market, the Australian Securities Exchange merits separate investigation, as it is small and concentrated on some sectors, when compared with the major developed markets. As realized returns are a proxy for expected returns, we separately examine conditional returns in upturn and downturn periods. We find that both downside risks are separately priced by investors, and that our results are unaffected by the inclusion of a range of company characteristics. We subsequently confirm that returns to each downside risk are not related. In robustness tests, we conclude that the return to downside risk cannot be explained by a size, a value, or a momentum premium. Although it also has explanatory power, the inclusion of a leverage factor also does not reduce the explanatory power of downside risk.     

Currency-related risk and risk premium in the world's currency market

The foreign exchange market has become a major arena for investment activity for both corporate and individual investors. Intensive and widespread international investment activity makes the empirical estimation of exchange risk a very topical subject. In this connection, the classic controversy between Hicks and Telser assumes new relevance. In this paper, exchange risk is estimated in the context of the systematic-risk framework. The estimation is performed for three major floating currencies: the English pound, the Swiss franc, and the Deutsche mark, over a four-year period. The results suggest that although the total risk (measured by the variance) is high, the systematic risk is close to zero. This result provides an explanation for the apparent inconsistency between the Hicks-Keynes hypothesis which indicates the existence of a positive risk premium in the forward exchange market and the empirical evidence of a zero risk premium.     

The effect of relative monetary surprises on spot exchange rates

This paper examines the hypothetical relationship between US and Canadian monetary surprises and the behaviour of US-Canadian spot exchange rates. Past studies have found that positive US monetary surprises were correlated with an appreciating US dollar in foreign exchange markets.

In this paper, it is argued that monetary surprises in the US must be measured relative to foreign monetary innovation (rather than in the conventional absolute sense) when examining their impact on exchange markets. Rational investors consider expected returns and risk differentials in the US and local markets jointly in determining whether to be net buyers or sellers of US dollars. The monetary actions of both the Fed and the Central Bank operating in the local (foreign) economy will be considered in the foreign exchange market. Because of the close synchronization between the weekly money supply announcements in Canada and the US, it is possible to examine whether the relative or absolute US monetary surprise is more significant in the foreign exchange market. The empirical findings provide considerable support for the relative over the absolute measure of US monetary innovations. With monetary innovations measured in relative terms, the empirical results provide support for the policy reaction over the inflation expectation hypothesis.     

Modelling VaR for foreign-asset portfolios in continuous time

VaR is widely viewed as a measure of market risk of a portfolio. The purpose of this article is to provide a VaR model for foreign-asset portfolios in continuous time. In the VaR model, the VaRs are not only a function of volatilities of asset returns and exchange rate but also a function of correlation coefficient between foreign assets and exchange rate. Moreover, by backtesting, the empirical results show that the new VaR model can efficiently evaluate the market risk of foreign-asset portfolios.     

How does a pay-as-you-go system affect asset returns and the equity premium?

When applying a differences-in-differences approach, equity returns and the equity premium are both estimated to be more than four percentage points higher after the introduction of a pay-as-you-go (PAYGO) system. In a realistically calibrated model, the PAYGO system is also found to increase the returns and the premium, although the effects are smaller than in the data. Intuitively, the system lowers asset prices, which in turn increases the importance of dividend risk. Since only equity is subject to dividend risk, equity returns become more volatile relative to bond returns.     

Endogenous uncertainty and market volatility

We advance the theory that the distribution of beliefs in the market is the most important propagation mechanism of economic volatility. Our model is based on the theory of Rational Beliefs (RB) and Rational Belief Equilibrium (RBE) developed by Kurz (1994, 1997). We argue that the diverse market puzzles which are examined, such as the equity premium puzzle, are all driven by the structure of market expectations. In support of our view, we present an RBE model with which we study financial markets. The model is able to simulate the correct order of magnitude of: (i) the long term mean and standard deviation of the price\dividend ratio; (ii) the long term mean and standard deviation of the risky rate of return on equities; (iii) the long term mean and standard deviation of the riskless rate; (iv) the long term mean equity premium. In addition, the model predicts (v) the GARCH property of risky asset returns; (vi) the observed pattern of the predictability of long returns on assets, and (vii) the Forward Discount Bias in foreign exchange markets. The common economic explanation for these phenomena is the existence of heterogenous agents with diverse but correlated beliefs such that some agents are optimistic and some pessimistic about future capital gains. The model has a unique parameterization under which the model makes all the above predictions simultaneously. The parameterization requires the optimists to be in the majority but the rationality of belief conditions of the RBE require the pessimists to have a higher intensity level. In simple terms, the large equity premium and the low equilibrium riskless rate are the result of the fact that at any moment of time there are agents who hold extreme pessimistic beliefs and they have a relatively stronger impact on the market. The paper also studies the effect of correlation of beliefs among investors. It shows that the main effect of such correlation is on the dynamic patterns of asset prices and returns and is hence important for studying such phenomena as stochastic volatility. Received: May 16, 2000; revised version: November 15, 2000