Working Paper: CEPR ID: DP3148
Authors: Peter N. Smith; Michael R. Wickens
Abstract: This Paper is an exploration into the links between macroeconomics and finance as they affect the FOREX risk premium. SDF theory is used in which the factors are observable macroeconomic variables. Three SDF theories are compared: a benchmark model based on traditional tests of FOREX efficiency; consumption-based CAPM; and the monetary model of the exchange rate. The theory takes account of both domestic and foreign investors. The joint distribution of the excess return to FOREX and the macro factors satisfies the no-arbitrage assumption, and is a suitably restricted version of multivariate GARCH-in-mean. Monthly data for the sterling-dollar exchange rate 1975-97 are used. The results suggest that the FOREX risk premium is best modelled by CAPM based and the factors that determine next period?s exchange rate.
Keywords: forex; GARCH; market efficiency; risk premium; stochastic discount factors
JEL Codes: F10; G10
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| macroeconomic factors (E66) | forex risk premium (F31) |
| US and UK output (E23) | forex risk premium (F31) |
| conditional covariance between excess returns and macroeconomic sources of risk (E19) | forex risk premium (F31) |
| differences in risk attitudes between domestic and foreign investors (G15) | forex risk premium (F31) |