Working Paper: NBER ID: w1749
Authors: Robert J. Hodrick; Sanjay Srivastava
Abstract: Fama(1984) analyzed the variability and the covariation of risk premiums and expected rates of depreciation. We employ three statistical techniques that do not suffer from a potential bias in Fama's analysis, but we nevertheless confirm his findings. In contrast to his interpretation the results are not necessarily at variance with the predictions of a theoretical model of the risk premium. Increases in expected rates of depreciation of the dollar relative to five foreign currencies are positively correlated with increases in the expected profitability of purchasing these currencies in the forward market, and risk premiums have larger variances than expected rates of depreciation.
Keywords: Risk Premiums; Exchange Rates; Market Efficiency
JEL Codes: F31; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| expected rate of depreciation (E43) | expected profit from buying dollars in the forward market (F31) |
| covariance of risk premiums and expected rate of depreciation (G19) | negative (Y70) |
| expected nominal marginal rates of substitution of the two currencies (F31) | negative covariance (C10) |
| variance of risk premium (D81) | variance of expected rate of depreciation (C29) |