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An Investigation of Risk and Return in Forward Foreign Exchange

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  • Robert J. Hodrick
  • Sanjay Srivastava

Abstract

This paper examines the determination of risk premiums in foreign exchange markets. The statistical model is based on a theoretical model of asset pricing, which leads to severe cross-equation constraints. Statistical tests lead to a rejection of these constraints. We examine the robustness of these tests to time variation in parameters and to the presence of heteroskedasticity. We find that there is evidence for heteroskedasticity and that the conditional expectation of the risk premium is a nonlinear function of the forward premium. Accounting for this nonlinearity, the specification appears to be time invariant. Out of sample portfolio speculaton is profItable but risky.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 1180.

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Date of creation: Aug 1983
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Publication status: published as Hodrick, Robert J. and Sanjay Srivastava. "An Investigation of Risk and Return in Forward Foreign Exchange." Journal of International Money and Finance, Vol. 3, No. 1, (April 1984), pp. 5-29.
Handle: RePEc:nbr:nberwo:1180

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  1. Frenkel, Jacob A, 1977. "The Forward Exchange Rate, Expectations, and the Demand for Money: The German Hyperinflation," American Economic Review, American Economic Association, American Economic Association, vol. 67(4), pages 653-70, September.
  2. Hodrick, Robert J., 1981. "International asset pricing with time-varying risk premia," Journal of International Economics, Elsevier, Elsevier, vol. 11(4), pages 573-587, November.
  3. Hansen, Lars Peter & Hodrick, Robert J, 1980. "Forward Exchange Rates as Optimal Predictors of Future Spot Rates: An Econometric Analysis," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 88(5), pages 829-53, October.
  4. Maurice Obstfeld & Robert E. Cumby & John Huizinga, 1983. "Two-Step Two-Stage Least Squares Estimation in Models with Rational Expectations," NBER Technical Working Papers 0011, National Bureau of Economic Research, Inc.
  5. John F. O. Bilson, 1980. "The "Speculative Efficiency" Hypothesis," NBER Working Papers 0474, National Bureau of Economic Research, Inc.
  6. Grauer, Frederick L. A. & Litzenberger, Robert H. & Stehle, Richard E., 1976. "Sharing rules and equilibrium in an international capital market under uncertainty," Journal of Financial Economics, Elsevier, Elsevier, vol. 3(3), pages 233-256, June.
  7. Grossman, Sanford J. & Shiller, Robert J., 1982. "Consumption correlatedness and risk measurement in economies with non-traded assets and heterogeneous information," Journal of Financial Economics, Elsevier, Elsevier, vol. 10(2), pages 195-210, July.
  8. Cumby, Robert E & Obstfeld, Maurice, 1981. "A Note on Exchange-Rate Expectations and Nominal Interest Differentials: A Test of the Fisher Hypothesis," Journal of Finance, American Finance Association, American Finance Association, vol. 36(3), pages 697-703, June.
  9. McKinnon, Ronald I., 1979. "Money in International Exchange: The Convertible Currency System," OUP Catalogue, Oxford University Press, Oxford University Press, number 9780195024098, October.
  10. Roll, Richard, 1977. "A critique of the asset pricing theory's tests Part I: On past and potential testability of the theory," Journal of Financial Economics, Elsevier, Elsevier, vol. 4(2), pages 129-176, March.
  11. André Farber & Eugene Fama, 1979. "Money, bonds and foreign exchange," ULB Institutional Repository 2013/11356, ULB -- Universite Libre de Bruxelles.
  12. Geweke, John F & Feige, Edgar L, 1979. "Some Joint Tests of the Efficiency of Markets for Forward Foreign Exchange," The Review of Economics and Statistics, MIT Press, vol. 61(3), pages 334-41, August.
  13. Hansen, Lars Peter, 1982. "Large Sample Properties of Generalized Method of Moments Estimators," Econometrica, Econometric Society, Econometric Society, vol. 50(4), pages 1029-54, July.
  14. Frankel, Jeffrey A., 1979. "The diversifiability of exchange risk," Journal of International Economics, Elsevier, Elsevier, vol. 9(3), pages 379-393, August.
  15. Craig S. Hakkio, 1980. "The Term Structure of the Forward Premium," NBER Working Papers 0426, National Bureau of Economic Research, Inc.
  16. Stulz, ReneM., 1981. "A model of international asset pricing," Journal of Financial Economics, Elsevier, Elsevier, vol. 9(4), pages 383-406, December.
  17. Longworth, David, 1981. "Testing the Efficiency of the Canadian-U.S. Exchange Market under the Assumption of no Risk Premium," Journal of Finance, American Finance Association, American Finance Association, vol. 36(1), pages 43-49, March.
  18. Hansen, Lars Peter & Singleton, Kenneth J, 1982. "Generalized Instrumental Variables Estimation of Nonlinear Rational Expectations Models," Econometrica, Econometric Society, Econometric Society, vol. 50(5), pages 1269-86, September.
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