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The risk premium in forward foreign exchange markets and G-3 central bank intervention: evidence of daily effects, 1985-1990

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Richard T. Baillie
William P. Osterberg

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Abstract

Evidence that forward rates for foreign exchange are not unbiased forecasts of future spot rates suggests a time-varying risk premium. However, there is little evidence that the forecast error is related to fundamentals, although most investigations have lacked high-frequency data. In this paper, we use daily exchange-rate and official Federal Reserve intervention data to test for an impact of intervention on the forecast error. This paper extends recent analyses of daily changes in exchange rates by Baillie and Bollersev (1989) and Hsieh (1989) to the daily forward-rate forecast errors for the dm/US$ and yen/US$ rates. We estimate an MA(21) process and utilize GARCH with a conditional student-t distribution. We find that 1) U.S. purchases of dollars on day t-1 affect the day t forecast error (ft-Et[st+k]), 2) there are day-of-the-week effects in the conditional variance, and 3) for the yen/US$ rate, there is GARCH-in-mean. These findings provide some support for considering intervention as a channel through which fundamentals influence risk premiaannel through which fundamentals influence risk premia.

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Paper provided by Federal Reserve Bank of Cleveland in its series Working Paper with number 9109.

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Date of creation: 1991
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Handle: RePEc:fip:fedcwp:9109

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Keywords: Foreign exchange - Law and legislation ; Risk;

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  1. William P. Osterberg, 1989. "Intervention and the risk premium in foreign exchange rates," Working Paper 8908, Federal Reserve Bank of Cleveland. [Downloadable!]
  2. Giovannini, Alberto & Jorion, Philippe, 1987. "Interest rates and risk premia in the stock market and in the foreign exchange market," Journal of International Money and Finance, Elsevier, vol. 6(1), pages 107-123, March. [Downloadable!] (restricted)
  3. Michael W. Klein & Eric S. Rosengren, 1991. "Foreign exchange intervention as a signal of monetary policy," New England Economic Review, Federal Reserve Bank of Boston, issue May, pages 39-50.
  4. Engel, Charles & Rodrigues, Anthony P, 1989. "Tests of International CAPM with Time-Varying Covariances," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 4(2), pages 119-38, April-Jun. [Downloadable!] (restricted)
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  5. Milhoj, Anders, 1987. "A Conditional Variance Model for Daily Deviations of an Exchange Rate," Journal of Business & Economic Statistics, American Statistical Association, vol. 5(1), pages 99-103, January.
  6. Richard Baillie, 1989. "Econometric tests of rationality and market efficiency," Econometric Reviews, Taylor and Francis Journals, vol. 8(2), pages 151-186. [Downloadable!] (restricted)
  7. Owen F. Humpage, 1991. "Central-bank intervention: recent literature, continuing controversy," Economic Review, Federal Reserve Bank of Cleveland, issue Q II, pages 12-26. [Downloadable!]
  8. E.K. Berndt & B.H. Hall & R.E. Hall, 1974. "Estimation and Inference in Nonlinear Structural Models," NBER Chapters, in: Annals of Economic and Social Measurement, Volume 3, number 4, pages 103-116 National Bureau of Economic Research, Inc. [Downloadable!]
  9. Michael W. Klein & Karen K. Lewis, 1991. "Learning About Intervention Target Zones," NBER Working Papers 3674, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  10. Domowitz, Ian & Hakkio, Craig S., 1985. "Conditional variance and the risk premium in the foreign exchange market," Journal of International Economics, Elsevier, vol. 19(1-2), pages 47-66, August. [Downloadable!] (restricted)
  11. Frankel, Jeffrey A & Froot, Kenneth A, 1987. "Using Survey Data to Test Standard Propositions Regarding Exchange Rate Expectations," American Economic Review, American Economic Association, vol. 77(1), pages 133-53, March. [Downloadable!] (restricted)
  12. Jeffrey A. Frankel & Kenneth A. Froot, 1987. "Using Survey Data to Test Some Standard Propositions Regarding Exchange Rate Expectations," NBER Working Papers 1672, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  13. M. R. Wickens, 1989. "Econometric tests of rationality and market efficiency," Econometric Reviews, Taylor and Francis Journals, vol. 8(2), pages 207-212. [Downloadable!] (restricted)
  14. Bossaerts, Peter & Hillion, Pierre, 1991. "Market Microstructure Effects of Government Intervention in the Foreign Exchange Market," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 4(3), pages 513-41. [Downloadable!] (restricted)
  15. McCurdy, T.H. & Morgan, I.G., 1989. "Evidence of risk Premia in Foreign Currency Futures Markets," UFAE and IAE Working Papers 130.90, Unitat de Fonaments de l'Anàlisi Econòmica (UAB) and Institut d'Anàlisi Econòmica (CSIC).
  16. Loopesko, Bonnie E., 1984. "Relationships among exchange rates, intervention, and interest rates: An empirical investigation," Journal of International Money and Finance, Elsevier, vol. 3(3), pages 257-277, December. [Downloadable!] (restricted)
  17. Diebold, Francis X & Nerlove, Marc, 1989. "The Dynamics of Exchange Rate Volatility: A Multivariate Latent Factor Arch Model," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 4(1), pages 1-21, Jan.-Mar.. [Downloadable!] (restricted)
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  18. Lewis, Karen K., 1988. "The persistence of the `peso problem' when policy is noisy," Journal of International Money and Finance, Elsevier, vol. 7(1), pages 5-21, March. [Downloadable!] (restricted)
  19. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November. [Downloadable!] (restricted)
  20. Mark, Nelson C., 1988. "Time-varying betas and risk premia in the pricing of forward foreign exchange contracts," Journal of Financial Economics, Elsevier, vol. 22(2), pages 335-354, December. [Downloadable!] (restricted)
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