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Asset price based estimates of sterling exchange rate risk premia

  • Jan J J Groen
  • Ravi Balakrishnan

In this paper we report estimates of the effective sterling, sterling/Deutsche mark and sterling/US dollar risk premia over a monthly 1987-2001 sample, generated using a conditional factor model for the stochastic discount factor of a representative 'worldwide' investor. The model relates this stochastic discount factor to the real return on a 'worldwide' stock portfolio, with the model parameters varying with variations in the slope of the 'world' term structure of interest rates. Econometric tests indicate that this model is accepted by the data. The corresponding parameter estimates are used to compute the risk premium for the three aforementioned sterling exchange rates. A graphical analysis indicates that, in terms of magnitude, our measure of the exchange rate risk premium is mainly of importance for the sterling/Deutsche mark exchange rate. Risk-adjusted test regressions for uncovered interest rate parity vis-`a-vis the major European currencies provide some confirmation for this.

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Paper provided by Bank of England in its series Bank of England working papers with number 250.

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Date of creation: Feb 2005
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Handle: RePEc:boe:boeewp:250
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