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.     

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.     

Excess Volatility of Realized Excess Profit from Currency Speculation in a Two-Country General Equilibrium Model

This paper examines whether the Lucas model can explain stylized facts in foreign exchange markets, by employing Monte Carlo studies. It is assumed that changes in the logarithms of endowments and of money supplies follow a multivariate Markov switching process. From the results of the Monte Carlo studies, with plausible values of the preference parameters, the excess volatility of the realized excess profit from currency speculation, the strong autocorrelation of the forward premium in the sample can be found in the model for four exchange rates. However, the implied covariance between the forward premium and depreciation rates is positive.     

The pricing of foreign exchange risk: Evidence from ADRS

This study investigates whether U.S. investors, in pursuing of international diversification, are exposed to foreign exchange risk through the ownership of American depository receipts (ADRs) and if so, whether such risk is systematic. We find that returns of ADRs from countries such as the United Kingdom, Japan, and South Africa are sensitive to their corresponding foreign exchange rate fluctuations. Using a technique developed by Sweeney and Warga (1986), we estimate the risk premium associated with foreign exchange risk. The results suggest that the total foreign exchange risk is priced at equilibrium. However, the incremental foreign exchange risk that is not imbedded in the market returns does not command a risk premium. The evidence indicates that the incremental foreign exchange risk is diversifiable or can be effectively hedged.     

Regional stock market integration in Singapore: A multivariate analysis

This paper evaluates the time-varying integration of the Singapore stock market in the ASEAN-5 region based on a conditional version of the International Capital Asset Pricing Model (ICAPM) with c-DCC-FIAPARCH parameters. This model allows for dynamic changes in the degree of market integration, regional market risk premium, regional exchange-rate risk premium, and domestic market risk premium. Our findings show several interesting facts. First, the time-varying degree of integration in the Singapore market is satisfactorily explained by the level of trade openness and the term premium of US interest rates, which have recently tended to increase, however these markets remain substantially segmented from the world market. Second, the local market risk premium is found to explain a significant proportion of the total risk premium for emerging market returns. Our findings illustrate several important implications for portfolio hedgers for making optimal portfolio allocations, engaging in risk management and forecasting future volatility in equity markets. Our results are also of interest for both policymakers and investors, with respect to regional development policies and dedicated portfolio investment strategies in the ASEAN-5 region.     

How strong is the global integration of emerging market regions? An empirical assessment

This paper attempts to evaluate the time-varying integration of emerging markets from a regional perspective based on a conditional version of the International Capital Asset Pricing Model (ICAPM) with DCC-GARCH parameters that allows for dynamic changes in the degree of market integration, global market risk premium, regional exchange-rate risk premium, and local market risk premium. Our findings reveal several interesting facts. First, the time-varying degree of integration of four emerging regions under consideration, satisfactorily explained by the regional level of trade openness and the term premium of US interest rates, has recently tended to increase, but these markets still remain substantially segmented from the world market. Second, the local market risk premium is found to explain more than 50% of the total risk premium for emerging market returns. Finally, we show that conditional correlations usually underestimate and overstate the measure of time-varying market integration. The empirical results of this study have some important implications for both global investors and policymakers with respect to dedicated portfolio investments in emerging markets and policy adjustments.     

State-uncertainty preferences and the risk premium in the exchange rate market

This paper shows that state-uncertainty preferences help to explain the observed exchange rate risk premium. In the framework of Lucas (1982) economy, state-uncertainty preferences amount to assuming that a given level of consumption will yield a higher level of utility the lower is the level of uncertainty perceived by consumers. Under these preferences we can distinguish between two factors driving the exchange rate risk premium: “macroeconomic risk” and “the risk associated with variation in the private agents' perception on the level of uncertainty”. Empirical evidence from three main European economies in the transition period to the euro provides empirical support for the model. The model is more successful in accounting for the observed currency risk premium than models with more standard preferences, and the general perception of risk by private agents is shown to be a more important determinant of risk premium than macroeconomic uncertainty.     

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 puzzling dual of the uncovered interest parity puzzle evidence from Pacific Rim capital flows

International financial arbitrage should prevent the existence of non-zero expected returns when borrowing in one currency and lending in another implying that interest differentials should predict exchange rate movements. The failure of interest differentials to act as an unbiased predictor of future exchange rate movements is referred to as the uncovered interest parity puzzle. This paper explores whether capital flows respond to these interest differentials in the context of a model in which dynamic adjustment costs keep capital from flowing immediately across borders. The paper finds little or even a negative relationship between expected excess returns on exchange rate adjusted U.S. money market rates (relative to domestic interest rates) and capital flows to the U.S. from Australia, Canada, Japan or Korea.     

Currency returns and downside risk: Debt,volatility, and the gap from benchmark values

The paper considers competing portfolio-balance specifications of currency returns, including one based on expected utility theory and another on prospect theory. The prospect theory specification relates downside risk to the gap between the exchange rate and its benchmark value. The empirical analysis uses survey data on exchange rate expectations to test directly the models’ predictions concerning ex ante excess returns. It also relies on the cointegrated VAR framework, which is well suited for testing competing models and dealing with unit roots. Like earlier studies, we find little support for the expected utility theory model in three major currency markets. By contrast, the prospect theory model’s predictions are largely borne out in the data, including those about sign reversals. We find the strongest support for a hybrid model that incorporates the risk factors of both models.     

Liquidity shocks: A new solution to the forward premium puzzle

The frequent empirical failure of uncovered interest rate parity raises a question that has not been definitively answered: why do predictable excess returns on currencies persist in competitive currency markets? Supported by data from nine major currencies for 1978:08–2019:09, I provide a novel resolution to this enduring forward premium puzzle by building on the financial economics literature that explores the economic implications of limited access to capital markets. A liquidity shock, or the urgent demand for liquidity by credit-constrained arbitragers liquidating bond holdings, causes losses from sudden drops in bond prices. Arbitragers require a liquidity premium to compensate for potential losses that vary directly with the interest rate. It is this liquidity premium that explains persistent excess returns on currencies. I argue for policies favoring a low interest rate environment and macroprudential controls that ease liquidity constraints to increase the efficiency of international capital markets by reducing the liquidity premium.     

Does the traditional exchange rate fully explain firms’ exposure?

This study aims to explore the role of the cross exchange rate as a form of market competition, which has previously been omitted as an explanatory variable in estimating the risk exposure of the standard exchange. To the end, we develop a model of exporting firms that reflects exposure to market interaction and mark-up in a duopolistic export market. Using monthly data of stock returns and cross exchange rates of two oligopoly industries (i.e. semiconductor and steel & iron), our empirical evidence supports our hypothesis that cross exchange rates significantly explain firm value.     

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.     

EMS exchange rate expectations and time-varying risk premia

In this paper we examine exchange risk premia employing a survey dataset of EMS exchange rates. We are able to test a risk premium model directly, i.e. without having to rely on the rational expectations assumption. Our results indicate that time-varying risk premia are present in almost all cases and that a GARCH-in-mean specification for the premium is often appropriate.     

Exchange Controls,Political Risk and the Eurocurrency Market: New Evidence from Tests of Covered Interest Rate Parity

This study employs daily data to examine the effects on Eurocurrency and onshore returns of the May 21, 1981 imposition of exchange controls by French President Mitterand. Prior to this time, transaction costs explain the average onshore deviations from covered parity; however, these averages ignore short-lived political risk premia which emerged just before the imposition of controls. As expected, there is no evidence of political risk of Eurocurrency markets. Yet when exchange controls were in effect, premia in excess of transaction costs surfaced on nonfranc Eurocurrency deposits at the time of devaluations of the franc within the EMS. [431]     

CAN FINANCING CONSTRAINTS EXPLAIN THE ASSET PRICING PUZZLES IN PRODUCTION ECONOMIES?*

General Equilibrium asset pricing models have a difficult time simultaneously delivering a sizable equity premium, a low and counter cyclical real risk free rate, and cyclical variation in return volatility. To explain these stylized facts, this article introduces occasionally binding financing constraints that impede producers’ ability to invest. The financial frictions drive a wedge between the marginal rate of substitution and firms’ internal stochastic discount factors so that the shadow value of capital is not tied to the average price of capital. The model delivers higher and more volatile asset returns during recessions as well as a counter cyclical equity premium.     

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.     

Uncovered Interest Parity at Long Horizons: Evidence on Emerging Economies*

This paper estimates uncovered interest parity (UIP) at long horizons using bilateral US dollar rates vis‐à‐vis mature economy and emerging market currencies. The paper finds support in favor of UIP for dollar rates vis‐à‐vis major mature economy currencies, but far less against emerging market currencies. There are also signs that political risk and the exchange risk premium help explain the empirical failure of UIP for these latter currencies. This suggests that whether UIP holds depends more on the currency than on the horizon.     

TREASURY NOTE AND BANK BILL RATES, THE RISK PREMIUM AND AUSTRALIAN MONETARY POLICY*

This paper examines a link in the Australian monetary transmission mechanism based on the risk structure of certain interest rates. Monthly data on the bank-accepted bill and Treasury note rates reveal a significant reduction in both the mean and variance of the risk premium linking the two rates towards the end of 1989. The two interest rates cointegrate in each of the periods January 1984 to September 1989 and October 1989 to December 1995, though less significantly so in the earlier period, and formal tests indicate that the risk premium was stationary for each of the sub-periods. Well defined error-correction mechanisms suggest that the burden of adjustment to shocks to the money market was shared by the two interest rates. A stationary risk premium, combined with evidence that the Treasury note rate Granger-caused the bank bill rate in both sub-periods, indicates that the Reserve Bank has been able to influence the bill rate by targeting the note rate.     

The real exchange rate and economic development

Recent empirical studies have found a robust correlation between competitive exchange rates and economic growth in developing economies. This paper presents (i) a formal model to help explain these findings and (ii) econometric evidence on the relation between investment and the real exchange rate. The model emphasizes the existence of (hidden) unemployment as a source of endogenous growth, even under constant returns to scale. Growth promoting policies, however, affect the external balance, and two instruments are needed in order to achieve targets for both the growth rate and the trade balance. The real exchange rate can serve as one of those instruments. The implications of the model for the relation between real exchange rates and the rate of capital accumulation find support in our econometric analysis.