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On biases in the measurement of foreign exchange risk premiums

  • Bekaert, Geert
  • Hodrick, Robert J.

The hypothesis that the forward rate is an unbiased predictor of the future spot rate has been consistently rejected in recent empirical studies. This paper examines several sources of measurement error and misspecification that might induce biases in such studies. Although previous inferences are shown to be robust to a failure to construct true returns and to omitted variable bias arising from conditional heteroskedasticity in spot rates, we show that the parameters were not stable over the 1975-1989 sample period. Estimation that allows for endogenous regime shifts in the parameters demonstrates that deviations from unbiasedness were more severe in the 1980's.

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Article provided by Elsevier in its journal Journal of International Money and Finance.

Volume (Year): 12 (1993)
Issue (Month): 2 (April)
Pages: 115-138

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Handle: RePEc:eee:jimfin:v:12:y:1993:i:2:p:115-138
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  1. Anne Sibert, 1987. "The risk premium in the foreign exchange market," Research Working Paper 87-07, Federal Reserve Bank of Kansas City.
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  5. Fama, Eugene F., 1984. "Forward and spot exchange rates," Journal of Monetary Economics, Elsevier, vol. 14(3), pages 319-338, November.
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  7. Engel, Charles, 1992. "On the foreign exchange risk premium in a general equilibrium model," Journal of International Economics, Elsevier, vol. 32(3-4), pages 305-319, May.
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  9. 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.
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  12. Hodrick, Robert J. & Srivastava, Sanjay, 1984. "An investigation of risk and return in forward foreign exchange," Journal of International Money and Finance, Elsevier, vol. 3(1), pages 5-29, April.
  13. Frenkel, Jacob A. & Razin, Assaf, 1980. "Stochastic prices and tests of efficiency of foreign exchange markets," Economics Letters, Elsevier, vol. 6(2), pages 165-170.
  14. Hodrick, Robert J., 1989. "Risk, uncertainty, and exchange rates," Journal of Monetary Economics, Elsevier, vol. 23(3), pages 433-459, May.
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  17. Lucas, Robert Jr., 1982. "Interest rates and currency prices in a two-country world," Journal of Monetary Economics, Elsevier, vol. 10(3), pages 335-359.
  18. Cornell, Bradford, 1989. "The impact of data errors on measurement of the foreign exchange risk premium," Journal of International Money and Finance, Elsevier, vol. 8(1), pages 147-157, March.
  19. Bossaerts, Peter & Hillion, Pierre, 1991. "Market Microstructure Effects of Government Intervention in the Foreign Exchange Market," Review of Financial Studies, Society for Financial Studies, vol. 4(3), pages 513-41.
  20. Korajczyk, Robert A. & Viallet, Claude J., 1992. "Equity risk premia and the pricing of foreign exchange risk," Journal of International Economics, Elsevier, vol. 33(3-4), pages 199-219, November.
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