Risk premia on foreign exchange in a cointegrated system

Abstract

This paper derives an explicit, direct model of the foreign exchange risk premium and uses it to test the time-variation and stationarity of foreign exchange risk premiums. It also examines the significance o f the forward market forecast error in explaining the risk premium. Assuming that returns in the foreign exchange market can be described by a diffusion-type stochastic process. it shows that the risk premium on foreign exchange is a weighted average (weighted by a finite time interval) of" the forward premium and the exchange rate risk-adjusted excess return to holding foreign exchange. We find that there exists a long-run equilibrium relationship between the forward premium and the risk- adjusted excess return in a co integrated system. The Johansen ( 199I) procedure for cointegration tests confirms that risk premiums are stationary and time-varying. The time-varying risk premium is reaffirmed by hypothesis tests performed using the ARCH- M model. The forward market forecast error appears to be justifiable in explaining the risk premium on foreign exchange.