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The risk premium in the foreign exchange market

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  • Anne Sibert

Abstract

This paper presents a dynamic, optimizing model of the risk premium in the forward foreign exchange market. Agents face random endowments and money growth rates. Complete insurance markets do not exist and foreign exchange is held to hedge against risk. In some examples with log-linear preferences, the size of the risk premium in the forward market is related to the variability of output and money growth. An interesting conclusion of the model is that for plausible examples, the convexity component of the nominal risk premium (due to Siegel's paradox) may be quite large relative to the total risk premium. Copyright 1989 by Ohio State University Press.

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Bibliographic Info

Paper provided by Federal Reserve Bank of Kansas City in its series Research Working Paper with number 87-07.

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Date of creation: 1987
Date of revision:
Handle: RePEc:fip:fedkrw:87-07

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Keywords: Foreign exchange ; Foreign exchange futures;

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Cited by:
  1. Bernard Dumas, 1993. "Partial- Vs. General-Equilibrium Models of the International Capital Market," NBER Working Papers 4446, National Bureau of Economic Research, Inc.
  2. Geert Bekaert & Robert J. Hodrick, 1991. "On Biases in the Measurement of Foreign Exchange Risk Premiums," NBER Working Papers 3861, National Bureau of Economic Research, Inc.
  3. Svensson, L.E., 1990. "The Foreign Exchange Risk Premium in a Target Zone with Devaluation Risk," Papers 475, Stockholm - International Economic Studies.
  4. Engel, Charles, 1996. "The forward discount anomaly and the risk premium: A survey of recent evidence," Journal of Empirical Finance, Elsevier, vol. 3(2), pages 123-192, June.
  5. Leduc, Sylvain, 2002. "Incomplete markets, borrowing constraints, and the foreign exchange risk premium," Journal of International Money and Finance, Elsevier, vol. 21(7), pages 957-980, December.
  6. Choudhry, Taufiq, 1999. "Re-examining forward market efficiency Evidence from fractional and Harris-Inder cointegration tests," International Review of Economics & Finance, Elsevier, vol. 8(4), pages 433-453, November.
  7. Edlin, Aaron S., 2002. "Forward Discount Bias, Nalebuff's Envelope Puzzle, and the Siegel Paradox in Foreign Exchange," Berkeley Olin Program in Law & Economics, Working Paper Series qt2wc1p9pw, Berkeley Olin Program in Law & Economics.
  8. Sonia PangusiĆ³n Espinosa., . "Testing Uncovered Interest Rate Parity: The Spanish case," Studies on the Spanish Economy 128, FEDEA.
  9. Kam Chu, 2005. "Solution to the Siegel Paradox," Open Economies Review, Springer, vol. 16(4), pages 399-405, October.
  10. Rankin, Neil, 1998. "Nominal rigidity and monetary uncertainty in a small open economy," Journal of Economic Dynamics and Control, Elsevier, vol. 22(5), pages 679-702, May.

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