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In this article, we review recent economic analyses Covered interest parity (CIP) relates the forward
of the risk premium’s role in foreign exchange mar premium (F’,— 5,1 to the interest differential,
kets. The starting point is an explanation of covered
~( j_~j* =
and uncovered interest parity and their relation to the
risk premium. We then turn to a discussion of empiri where
cal tests of efficiency. In particular, we examine Iwo
= log of I plus 13.5. threemonth Tbill interest
recent papers that demonstrate the existence of the
rate,
risk premium but differ in their conclusions about
market efficiency: Fama 1984; and Frankel and Froot = log of 1 plus foreign equivalent of Thill
(1986( rate,
5
FEDERAL RESERVE BANK OF ST. LOUIS DECEMBER 1987
exchange pusition — that is. a spot purchase offoreign the log of the forsyard rate and the log of the expected,
currency offliet by a forward sale. The equality with the hut unobservable, future spot rate,
differential between the domestic and foreign interest
5 P, = F,— E[S,.~’,.
rate on the lefthand side is brought about by arbi
trage: since the bonds are assumed to be default free For instance, if the risk premium is positive, specula
in their respective currencies, a riskless excess return tots sell foreign currency forward at price F, and ex
would be available if CIP did not hold.’ pect to he able to buy the foreign currency spot at time
+k for E,S. ~, profiting by doing so at rate P (annual
Because the forward rate is the present contractual
rate aP,(. Note that, if the risk premium is not zero, the
dollar price of foreign currency for future delivery, the
ntaiket actually can expect the dollar to depreciate,
assumptions of market efficiency and no risk pre
even though the observed interest differential and the
mium imply a second form of interest paiit~called
forward premium indicate an appreciation of the dol
uncovered interest parity (UIP(. An expression fur VIP
lar.’
can he obtained from the arbitrage condition which
equates the expected change in the spot rate plus the Risk Premium or Market Inefficiency
premium for risk with the forward premium:
Current investigations of the relationship between
(2( E,[S,.kl—S, ±P. =
the spot and forward exchange rates are premised on
s.x’here a widely documented finding: the simple norisk
premium efficiency criterion, defined jointly by equa
EjS, = the expectation of the periodt + k
tions 2 and 3, has been refuted by many empirical
spot rate based on periodt inforrna studies. Using a variety of assumptions, data, time
tion, periods and estimation techniques, investigators have
P = the risk premium for bearing the uncer— established three fundamental points:
taints’ of unexpected currency price ii The forward exchange iate is not an unbiased pre
changes. dictor of the future spot rate.
Under the noriskpremium hypothesis, z ‘rhe residuals obtained in a regression of spot ex
change rates of their lagged forward rates liv
(3; p,=0, quenttv exhibit serial conelation,
3) There exist systems filters; that permit profitable
then, from (Ii, we have the second form of interest
sper:ulation in fureign exchange either through the
parity, VIP:
pur’cbase of foreign assets u•’ith offsetting forward
(4( i — i’ = (E,[S, , k] — Sja. exchange sales or buy and hold strategies.
6
FEDERAL RESERVE BANK OF ST. LOUIS DECEMBER 1987
Given the ample empitical evidence, most researchers The first paper is F’ama’s 1984) article, which as
accept the rejection of the simple noriskpremium sesses the relative variability of the risk pr’emium and
efficiency criterion; however, they remain divided on forecast errors during 1973—82. Fama concludes that
whether the existence of a risk premium or market the risk premium explains more of the var’iance than
inefficiency is responsible for this result. the forecast error does.Fur1hermore, he also finds that
the iisk premium and the expected (but unobserved;
Why has it been so difficult to test for the presence
future spot rates atc negatively crtrelated.
of a risk premium? The answer’ is that while, in gen
eral, we do not have actual cx ante expectations data, The second paper, Frankel and Froot (1986;, uses
we assume that foreign exchange market participants the median response from survey data of foreign ex
are rational in their decisions, including their pricing change traders’ expectations of future spot rates.’
of risk. Hence, the expectation of the future spot rate is Their study, primarily covering 1981—85, finds a risk
equal to its actual, subsequently observed value plus a premium varying between 3 percent and 10 percent
random ertor and, perhaps, a risk premium. Conse depending on the currency observed. Thus, they are
quently, whenever the observable value of F,—S,~k is able to test directly the rational expectations hypothe
different from zero, there is cx post evidence on the sis and to estimate the proportion of the forward rate
existence of a risk premium or market inefficienc or error’ that can be ascribed to forecast error and to risk
both, but no direct evidence bearing on which.~ premia.
The empirical difficulties in assessing the presence Their findings concur with Fama’s in two respects
of a risk ptemium fiom simple calculations of F,—S,., — the risk premium is significant and negatively cor
can he gathered from chart 1. In this chart, we have related with the expected future spot rate — but
plotted the socalled ey post or rational expectations diverge in terms of the relative variances of forecast
risk premium, F—S. ‘ (annualized;, for the dollar/ errors and risk premia:
deutsche mark exchange rate from January 1976 In all three surveys, the errors exhibit unconditional
through June 1985. As is eyident, it is difficult to show bias ofa sign opposite to estimates of the r’isk premium
that the forward iate systematically underpredicts or from the survey data. The premia are large in absolute
overptedicts the future spot rate. When long periods value, and are statistically different from zero. We can
of time are consideted, the average prediction errot of reject the hypothesis that systematic unconditional
mistakes made by the forward rate in predicting the
the forward exchange rate is close to zero. Fortunately, future spot r’ate are due entir’elv to a failure of rational
however, two direct tests for the presence of a risk expectations. But at the other extreme, the hypothesis
premium in the foreign exchange market have em that the forward rate prediction errors can be ex
erged from the literature. plained by the risk premium alone is also r’ejected.
Expected depreciation is more variable than both the
forward discount and the risk premium. The first find
ing corroborates Fama’s 1984) conjecture that ex
pected depr’eciation and the risk premium are nega
TWO TESTS OF EFFICIENCY AND tively correlated. ‘t’he second finding rejects the
RISK PREMIA hypothesis that the variance of expected depreciation
is less than the variance of risk premium
Recently, two studies of exchange rates have offered
tests that sepatate the tational expectations hvpothe—
sis and the existence of a risk premium. These papeis
use different methods, time periods and data sets, and ‘Frankel and Froot used three different surveys: Money Market
they arrive at clifferent conclusions about the relative Services (MMS), Inc., biweekly January 1983—October 1984,
importance of the risk premium and expectation er weekly 1984—86, polled an average of 30 currency traders or
economists at major international banks; The Economist Financial
rot’s. Report every six weeks June 1981—December 1985 conducted
telephone interviews with currency traders at 14 leading interna
tional banks; finally, Amex Bank Review 1976—85 annually sur
veyed 250—300 central and private bankers, corporate officers and
economists. In each case, respondents were asked for exchange
rate forecasts at various horizons for the pound, mark, Swiss franc,
‘Of course, this is conditional on expectations being rationally yen and (except for MMS) French franc. Details of these surveys
formed, Even so, unforeseen events transpiring between time t and can be found in the data appendix of Frankel and Froot (1987), p.
+‘k may result in F,—S,K ± 0. Such unforeseen events, dubbed 151.
“news” by Frenkel (1981) explains some variation in F,—S,,,due °Frankeland Froot (1986), p. 29. Originally, this negative correlation
neither to a risk premium nor nonrational expectations; however, was presented by Fama (1984) as a puzzle; however, as shown in
news should not result in biased expectations since unforeseen Hodrick and Srivastava (1986), it is perfectly consistent with the
events must have an expected meafl of zero. intertemporal asset pricing model of forward exchange markets.
7
FEDERAL RESERVE BANK OF St LOUIS DECEMBER 1987
0 0 0 0 0
~ 0
~2
‘a
5 —
‘a ‘a
—I
S
0~
In
0~
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t
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‘W~ 0
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t
C
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4)
S
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a r CO
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0’ a 5
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8
FEDERAL RESERVE BANK OF ST. LOUIS DECEMBER 1987
9
FEDERAL RESERVE BANK OF ST. LOUIS DECEMBER 1987
iThal is, when distributions are not symmetric, the different statistics and
that survey respondents might interpret as expectations’ will be
wid&y divergent. When thstributions of future spot exchange rates b2 cov(S .2I — S~,F,— 5)
1 (F~— S)
(7
are symmetric, the mean and mode (most likely future exchange
rate) are the same. Also, Ihe odd moments of a symmethc d~stribu = (F2(E,(S .~ —~ S,) ) * coy (P,, E,(S — S,) )
tion are zero, so that skewness could not influence a survey respon 1
dents answer. If distributions are asymmetric, however, the mean — S,)
and mode will diverge and nonzero skewness (the third moment of
the distribution) nhluence the risk premium and, hence, the survey Since the covariance term appears in the bi and b2 regression
response. For example, consider two alternative distributions for the coefficients, neither bi nor b2 can be used by itself to assess the
DM one month in the future: relative contribution of risk or forecast error to the forward premium;
however, since they have a common denominator, r2(F,~S),the
I. Symmetric Distribution (likelihood) difference between bi and b2, which does not contain this term in
$667 (10%). $606 (80%), $545 (10%). the numerator, can be used to provide evidence about the propor
II. Asymmetric Distribution (likelihood) tional contribution or risk and forecast error,
$667 (20%), $606 (80%) 1
(12(P) — (T (E(S~~
, ‘— S,)
In each distribution, the mode is $606. which is aiso the mean of I
but, the mean of II is $618. Thus, the statistEc that respondents
bl—b2
fl.2 (F, S,) —
repoit as theft expected va~uematters for distribution U, but does not l4The standard error of bi — b2 is twice the common standard error of
matter for distrthutEon I. bi and b2: Since (6) and (7) mp~ythat b, ±b = 1, by definition of
2 the variance of b, 2
Frankel and Froot (1986) use spot and forward exchange rate data
from DRL while Fama (1984) uses data from Harris Trust Nafion& T(b ~b2) [E(b, b, — —
(b — b ) )2]V2
Bank of Chicago. In the results reported fl tables I and 2, we use [E(b,  
2 2
1

(1 6.) + (I b ) )91/2
DRI data. = 2a(b).
10
FEDERAL RESERVE BANK OF ST. LOUIS DECEMBER 1987
Fama’s Specjfication Estimated by before ~B), duting (DY and since (SI the interval of
monetary aggiegate targeting, 1979.1O—198Z.O9,’~
Subperiods, 1976—85
Fstatistics for tests of these structural breaks over
One possible reason that different sample peiiods
the 1976—85 period against the null hypothesis of no
Fama 197382; FrankelFroot, 1981—85) yield different
breaks are reported in table 1. These Chow tests are
results is that the structure of markets was’ have
used to determine the proper estimation subperiods
changed during or between these periods. Econo
to be reported in table 2. As the first column oltablé 1
mists have argued that the socalled peso problem indicates, Canada, France, Italy Japan and Switzer
makes the 1973—76 period difficult to intcTpret±0th—
land do not ieject the hillperiod structural stability
eis have aigued that the development of foreign ex
hypothesis, and their regression estimates in table 2
change markets, learning curve behavior of agents and are for the undivided full period, indicated by
the evolution of floating exchange rate policy are other
B + I) + S. Belgium, Germany, the Netherlands and the
reasons why subpenods may differ in structure. In
Uniled Kingdom reject the null hypothesis at the 5
partiuular, seveiaI authors have presented evidence
percent level or better, and their regression estimates
that a change in the monetaiv 1egirne in the United
are reported by the appropriate subperiods.’~
States during the last quarter of 1979 may have caused
a sliuctural change.~ Consequently, we have esti Table 2 reports the regression estimates of (6) and (7)
mated Fama’s model, equations C and 7, over all COW— for the nine currencies whose structures were exam
binations of the three subperiods of 1976.01—1985,06: ined in table 1. Overall, the bi —b2 test reported in the
ThThe ater starting dale also avoids the peso probtem; see Krasker
1~The peso problem refers to the deva(uation of the Mexican peso
(1979).
which was anUcipated throughout the 1973—76 period and which
occurred n ear’y 1976. More generauy, it refers to any anticipated ‘~tnte~estingly.the data for none of the countries supported the
exogenous event that does not occur within the sample period. See afternative hypothesis that the Before and Since subperiods were
Krasker (1979) and lsard (1987). the same. Germany and B&gium provided evidence that all three
6 periods were d~ssjmilar,white the Netherlands and the United King
See Isard (1987). dom indicated that the Before and During subperiods were similar
“‘For example, see Ott and Veugelers (1956) and Frenkel (1986). but ointly different from the Since subperiod.
11
FEDERAL RESERVE BANK OF ST. LOWS DECEMBER 1987
last column reasserts the relative importance of the pects to other(domestic) financial markets so that the
risk premium that Fama found in his original tests. hypothesis of efficiency is plausible. Empirical tests,
This result holds both for currencies that revealed however, have rejected the joint hypothesis of market
structurally differentiated subperiods and for curren efficiency and no risk premium in the foreign ex~
cies that did not, that is, Canada, Italy, Japan and change market. That is, while CIP holds, UIP does not.
Switzerland. Of the nine currencies only the Belgian
Consequently, the role of the risk premium in for
franc and the French franc failed to support the statis
eign exchange markets often was not distinguishable
tically greater importance oIthe risk premium over the
from market inefficiency until Fama’s 1984) analysis
expected change in the exchange rate.zO The other
provided a test of its importance in the foreign ex
results reported in table 2 indicate that the results are
change market. Frankel and Front (19861 have pro
quantitatively sirn~1arto those reported by Farna for
vided survey~based evidence that also supports the
the same currencies over a shorter sample and differ
existence of a risk premium but conflicts with Fama’s
ent data set.
assessment of the risk premium’s economic impor
tance. We have replicated Fama’s study for an ex
CONCLUSION tended sample period and, although the results varied
substantially by subperiods, found results that in gen
Markets for foreign exchange are wellorganized, eial corroborate Farna’s findings. What this impasse
highvolume interactions that encompass the trading
suggests is that the economic significance of the risk
activities of many competitive profitseeking agents. premium will not be resolved by tests of its existence
That is, they appear similar in many functional as but may require direct modelling of the portfolio
2
choice problem from which it arises ’
20
—
But even for Beigkim and France, the difference bl b2 was posi
For an application of portfolio choice theory to this prob’em, see
tive so that forecast error variance was not greater than risk preniia 21
12
FEDERAL RE$ERV~BANK OF ST. LOWS DECEMBER 1987
13