Working Paper: NBER ID: w1180
Authors: Robert J. Hodrick; Sanjay Srivastava
Abstract: This paper examines the determination of risk premiums in foreign exchange markets. The statistical model is based on a theoretical model of asset pricing, which leads to severe cross-equation constraints. Statistical tests lead to a rejection of these constraints. We examine the robustness of these tests to time variation in parameters and to the presence of heteroskedasticity. We find that there is evidence for heteroskedasticity and that the conditional expectation of the risk premium is a nonlinear function of the forward premium. Accounting for this nonlinearity, the specification appears to be time invariant. Out of sample portfolio speculaton is profItable but risky.
Keywords: foreign exchange; risk premium; asset pricing; market efficiency
JEL Codes: F31; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| forward premium (G13) | risk premium (G19) |
| risk premium (G19) | forward premium (G13) |
| risk-return tradeoff (G11) | market inefficiencies (G14) |
| risk premium (G19) | deviations from unbiasedness hypothesis (C46) |