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Tests of the foreign exchange risk premium using the expected second moments implied by option pricing

  • Lyons, Richard K.

This paper applies a new method to investigate the foreign exchange risk premium. The method is new in the sense that it utilizes the time-varying second moment expectations implied by foreign currency option pricing. The vast empirical literature on the risk premium generally neglects the role of time-varying second moments, in spite of their importance in assessing risk-return tradeoffs. In fact, this importance is borne out in the data: time-varying expectations generate valuable new evidence regarding both unbiasedness in the forward rate and portfolio balance models. Moreover, the results suggest that previous tests which assume constant second moments involve serious misspecification errors. The results also highlight the unreliability of the portfolio balance effects of sterilized intervention, in spite of the quantitative importance of expected return differentials.

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

Volume (Year): 7 (1988)
Issue (Month): 1 (March)
Pages: 91-108

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Handle: RePEc:eee:jimfin:v:7:y:1988:i:1:p:91-108
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/30443

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  1. Shastri, Kuldeep & Tandon, Kishore, 1986. "Valuation of Foreign Currency Options: Some Empirical Tests," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 21(02), pages 145-160, June.
  2. 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.
  3. Solnik, Bruno H., 1974. "An equilibrium model of the international capital market," Journal of Economic Theory, Elsevier, vol. 8(4), pages 500-524, August.
  4. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
  5. Fama, Eugene F & Farber, Andre, 1979. "Money, Bonds, and Foreign Exchange," American Economic Review, American Economic Association, vol. 69(4), pages 639-49, September.
  6. Orlin J. Grabbe, . "The Pricing of Call and Put Options on Foreign Exchange," Rodney L. White Center for Financial Research Working Papers 6-83, Wharton School Rodney L. White Center for Financial Research.
  7. Orlin Grabbe, J., 1983. "The pricing of call and put options on foreign exchange," Journal of International Money and Finance, Elsevier, vol. 2(3), pages 239-253, December.
  8. Orlin J. Grabbe, . "The Pricing of Call and Put Options on Foreign Exchange," Rodney L. White Center for Financial Research Working Papers 06-83, Wharton School Rodney L. White Center for Financial Research.
  9. Cox, John C. & Ross, Stephen A. & Rubinstein, Mark, 1979. "Option pricing: A simplified approach," Journal of Financial Economics, Elsevier, vol. 7(3), pages 229-263, September.
  10. 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.
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  12. Patell, James M. & Wolfson, Mark A., 1979. "Anticipated information releases reflected in call option prices," Journal of Accounting and Economics, Elsevier, vol. 1(2), pages 117-140, August.
  13. Engle, Robert F, 1982. "Autoregressive Conditional Heteroscedasticity with Estimates of the Variance of United Kingdom Inflation," Econometrica, Econometric Society, vol. 50(4), pages 987-1007, July.
  14. Frankel, Jeffrey A., 1982. "In search of the exchange risk premium: A six-currency test assuming mean-variance optimization," Journal of International Money and Finance, Elsevier, vol. 1(1), pages 255-274, January.
  15. 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.
  16. Robert C. Merton, 1973. "Theory of Rational Option Pricing," Bell Journal of Economics, The RAND Corporation, vol. 4(1), pages 141-183, Spring.
  17. Robert E. Cumby & Maurice Obstfeld, 1980. "Exchange-Rate Expectations and Nominal Interest Differentials: A Test ofthe Fisher Hypothesis," NBER Working Papers 0537, National Bureau of Economic Research, Inc.
  18. Latane, Henry A & Rendleman, Richard J, Jr, 1976. "Standard Deviations of Stock Price Ratios Implied in Option Prices," Journal of Finance, American Finance Association, vol. 31(2), pages 369-81, May.
  19. Rahman, Abdul & Kryzanowski, Lawrence, 1986. "Alternative specifications of the errors in the Black-Scholes option-pricing model and various implied-variance formulas," Economics Letters, Elsevier, vol. 21(1), pages 61-65.
  20. Jeffrey A. Frankel & Charles Engel, 1982. "Do Asset-Demand Functions Optimize over the Mean and Variance of Real Returns? A Six-Currency Test," NBER Working Papers 1051, National Bureau of Economic Research, Inc.
  21. Beckers, Stan, 1981. "Standard deviations implied in option prices as predictors of future stock price variability," Journal of Banking & Finance, Elsevier, vol. 5(3), pages 363-381, September.
  22. Bodurtha, James N, Jr & Courtadon, Georges R, 1986. " Efficiency Tests of the Foreign Currency Options Market," Journal of Finance, American Finance Association, vol. 41(1), pages 151-62, March.
  23. Garman, Mark B. & Kohlhagen, Steven W., 1983. "Foreign currency option values," Journal of International Money and Finance, Elsevier, vol. 2(3), pages 231-237, December.
  24. Paul R. Krugman, 1981. "Consumption Preferences, Asset Demands, and Distribution Effects in International Financial Markets," NBER Working Papers 0651, National Bureau of Economic Research, Inc.
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