RISK PREMIA IN FOREIGN EXCHANGE MARKETS

We have attempted to test the existence of time-varying risk premia in foreign exchange markets under two models that we have developed in this dissertation. This first one is an extension to Lucas's general equilibrium model of international finance. By assumption of the Cobb-Douglas utility function of the consumers we are able to derive a closed form for the risk premia in the foreign exchange markets on the setting of a two-country economy model. We used White's test and Engle's test for homoscedasticity and used White's heteroscedasticity-consistent variance-covariance matrix to derive the correct standard errors. The time varying risk premium is tested jointly with the efficiency of the foreign exchange market, i.e., whether the forward exchange rates are unbiased predictors of the future spot exchange rates. The empirical findings indicate that the notion of market efficiency is rejected and there is no risk premium for any of the three cases we studied.; In the monetary approach, however, we test the existence of time-varying risk premia alone. By PPP and an extension to the uncovered interest parity we introduced the risk premia into our monetary approach to foreign exchange rate determination. The forward premium is used as a driving force of the risk premium. A rational expectation hypothesis is made and the forward solution derived.; Since it is a non-linear single equation model and there is evidence of heteroscedasticity we used GMM estimators and the corresponding variance-covariance matrix and found that there are constant risk premia in the case of Germany and Japan but not in the case of Canada.; We also did an empirical study of monetary model with the formation of risk premium derived before. The findings we have are that there is time-varying risk premium in the case of Germany but not in the cases of Japan and Canada.; Since our monetary model relaxes the restriction imposed on the semi-elasticity of interest rate the empirical results are based on a more general setting than most of the monetary models of foreign exchange rates. The conflicting empirical results from the two attempts are attributed to the different setting of the models.; Extensions to the current data will test whether the conclusion we have drawn is valid.