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.     

The Risk Premium, Exchange Rate Expectations, and the Forward Exchange Rate: Estimates for the Yen–Dollar Rate

The hypothesis that the forward rate is an unbiased predictor of the future spot rate has been rejected in many empirical studies. The rejection of this hypothesis could occur because market behavior is inconsistent with rational–expectations or because there exists a risk premium. Equations describing the forward premium and the change in the exchange rate are estimated jointly, and tests of both the rational–expectations and no–risk–premium hypotheses are conducted. Empirical estimates, obtained using quarterly data for the yen–dollar exchange rate, reject the rational–expectations hypothesis and suggest that there exists a time–varying risk premium.     

Exchange Rate Expectations and the Risk Premium: Tests For A Cross Section of 17 Currencies*

Survey data on a broad cross section of 17 currencies are used to determine whether the forward discount moves primarily in response to changes in expectations of depreciation, or in the risk premium. We find that, in contrast to earlier studies involving developed country exchange rates, variation in the risk premium is a quantitatively significant factor in movements of the forward discount. However, changes in expectations also have a substantial effect.     

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.     

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.     

The Common Component in Forward Premiums: Evidence from the Asia–Pacific Region

We empirically analyze the behavior of the forward premium. Unlike previous research, we use data from Asia–Pacific countries and adopt a panel data approach that allows us to decompose the forward premium into common and idiosyncratic components. Our data suggest the presence of one common factor and the stationarity of both components for short maturities, leading to the conclusion of a stationary forward premium. In contrast, the stationarity of the premium is less supported by the longer maturity data. Furthermore, a large portion of the premium fluctuation is shown to be due to a common factor, particularly over the short time horizon, which in turn can be explained by economic developments in the USA.     

Experimental Foreign Exchange Markets

The paper analyzes experimental markets where subjects buy and sell two different assets. The assets' properties vary across treatments, and their relative price is the exchange rate. Although both assets uniformly exhibit bubbles, the exchange rate satisfies cross‐currency arbitrage. There is no evidence of a positive risk premium in these markets, and almost all subjects' forecasts of the exchange rate are rational.     

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.     

Forward discount dynamics in integrated markets

This paper models the excess return or forward discount (premium) dynamics in integrated markets. Its decomposition at different time frequencies suggests that both stochastic and fundamental processes, as well as exogenous random shocks, are relevant for the determination of the forward discount (premium) over time. A stochastic process within a time-dependent parabolic well appears to capture the empirical findings of the literature and provides the means for the derivation of the equilibrium pricing formula for the forward discount. The mathematical solution that determines the relationship between the stochastic process and the trend allows for an interpretation of the reasons why, in some cases, expectational error appears to be correlated with the forward discount (premium) but not with the forward risk premium. Finally, estimations of the forward discount are carried out using the proposed model, which seems to support the data well.     

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.     

Sovereign Risk and Out‐of‐Equilibrium Exchange Rate Dynamics

We show that the sovereign risk premium contains important information on short‐run exchange rate dynamics in emerging economies. Net foreign assets serve as the key link between both variables, which acts as a “crude form of collateral.” We present two sets of empirical evidence. First, we show that increases in net foreign assets provide a statistically significant reduction on emerging markets sovereign risk premium. Then, we show that out‐of‐sample forecasts using realized values for the sovereign risk premium have a satisfactory performance when evaluated across three metrics: the mean squared error ratio, the direction of change statistic, and the consistency criterion.     

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.     

Determinants of the premium in forward contracts

Whilst the benefits of forward contracting for goods and services have been extensively researched in terms of mitigating market power effects in spot markets, we analyse how the risk in spot price formation induces a counteracting premium in the contract prices. We consider and test a wide-ranging set of propositions, involving fundamental, behavioural, dynamic, market conduct and shock components, on a long data set from the most liquid of European electricity forward markets, the EEX. We show that part of what is conventionally regarded as the market price of risk in electricity is actually that of its underlying fuel commodity, gas; that market power has a double effect on prices, insofar as it increases spot prices and induces a forward premium; that oil price sentiment spills over and that the premium reacts to scarcity and the higher moments of spot price uncertainty. We observe that considerations of the scale and determinants of the forward premium are at least as important as the market power effects in spot market price formation when evaluating the efficiency of wholesale power trading.     

COMMON FACTORS OF THE EXCHANGE RISK PREMIUM IN EMERGING EUROPEAN MARKETS

Existing empirical evidence suggests that the Uncovered Interest Rate Parity condition may not hold due to an exchange risk premium. For a panel dataset of eleven emerging European economies we decompose this exchange risk premium into an idiosyncratic (country‐specific) element and a common factor using a principal components approach. We present evidence of stationary idiosyncratic and common factors. This result leads to the conclusion of a stationary risk premium for these countries, which is consistent with previous studies often documenting a stationary premium in advanced countries. Furthermore, we report that the variation in the premium is largely attributable to a common factor influenced by economic developments in the United States.     

Rationality and the Risk Premium on the Australian dollar

A Model of the forward rate error of the USD/AUD spot exchange rate is fitted to daily data for the period 15th December 1983 to 31st December 1991. This provides a data set of 2034 daily trading observations. Explanations of the forecast error include a risk premium represented by a constant plus the conditional variance generated from a GARCH (1,1)-M analysis of the error process and information variables in the form of lagged forward rate errors. The following conclusions are drawn form estimates for the full sample: the USD/AUD spot rate is subject to a constant premium: there is little evidence to support a time varying component and the market is influenced by lagged forward errors. Sub period estimation confirms these results, although a time varying premium is evident prior to the February 1985 depreciation. The economic implications of these findings are discussed. [F31]     

Forward Markets and the Behaviour of the Competitive Firm with Production Flexibility

This paper examines the production and hedging decisions of the competitive firm under output price uncertainty when a forward market for its output is available. The firm possesses production flexibility in that it makes its production decision after the resolution of the output price uncertainty, albeit subject to a capacity constraint on production. We show that the firm optimally acquires a higher level of capacity investment than an otherwise identical firm with no production flexibility. We further show that production flexibility allows the firm to implicitly hedge against its output price risk exposure by the ex post production decision. The firm as such under‐hedges its output price risk exposure in the forward market wherein the forward price contains a non‐positive risk premium.     

Uncovered interest parity in Central and Eastern Europe: Expectations and structural breaks

This paper examines the empirical validity of the hypothesis of uncovered interest parity (UIP) using data from five Central and Eastern European countries with floating exchange rates for the period 2003 to 2014. The analysis includes forward‐looking as well as static expectations and allows for different types of structural break. The variable depicting the deviation from strict UIP is stationary when expectations are forward looking, suggesting that it is not possible to reject the UIP hypothesis with a constant risk premium. The deviation from strict UIP is however typically not stationary when expectations are static, even when structural breaks are incorporated, leading to the rejection of the UIP hypothesis with a constant risk premium. The results underscore the central role of expectations for the UIP hypothesis.     

Volatility spillovers and the price of risk: Evidence from the Swiss stock market

This paper investigates the behavior of the risk premium on the Swiss stock market. The risk premium consists of two components, which are estimated separately: the amount of volatility and the unit price of risk. By estimating a bivariate GARCH-M model the volatility of the Swiss market is found to be strongly exposed to spillovers from the other major financial markets. To estimate the unit price of risk a Kalman filter procedure is employed, which allows for variability in this variable. Investors place a high price on risk, when the market is considered `expensive'. First version received: March 1998/final version received: July 1998     

Premium auctions and risk preferences

In a premium auction, the seller offers some “payback”, called premium, to a set of high bidders at the end of the auction. This paper investigates how the performance of such premium tactics is related to the bidders? risk preferences. We analyze a two-stage English premium auction model with symmetric interdependent values, in which the bidders may be risk averse or risk preferring. Upon establishing the existence and uniqueness of a symmetric equilibrium, we show that the premium causes the expected revenue to increase in the bidders? risk tolerance. A “net-premium effect” is key to this result.     

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.