DP3148 Macroeconomic Sources of FOREX Risk

Author(s): Peter N Smith, Michael R. Wickens
Publication Date: January 2002
Keyword(s): FOREX, GARCH, market efficiency, risk premium, stochastic discount factors
JEL(s): F10, G10
Programme Areas: International Macroeconomics, Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=3148

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.