Working Paper: NBER ID: w2678
Authors: Fabio Canova; Takatoshi Ito
Abstract: The purpose of this paper is to characterize the changes in risk premium in the 1980s. A five-variable vector autoregressive model (VAR) is constructed to calculate a risk premium series in the foreign exchange market. The risk premium series is volatile and time-varying. The hypothesis of no risk premium is strongly rejected for the entire sample and each of the two subsamples considered. Various tests using the constructed risk premium series suggest that a risk premium existed but it was neither constant nor stable over subsamples and that its volatility was considerably reduced after October 1982.
Keywords: risk premium; foreign exchange market; vector autoregressive model; time-varying
JEL Codes: C32; F31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Risk premium exists in the yen-dollar exchange market (F31) | Risk premium is volatile and time-varying (G19) |
| Monetary policy regime influences risk premium's time series properties (E43) | Risk premium dynamics are affected (G19) |
| Risk premium volatility was significantly reduced after October 1982 (G19) | Risk premium behavior is influenced by time (G40) |
| Risk premium is defined as the difference between expected spot rate and forward rate (E43) | Correlation with expected change in spot rate can be inferred (E43) |
| Interest rates influence risk premium dynamics (E43) | Risk premium behavior is affected (G40) |