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

Abstract

This paper utilizes the second moment expectations implied by currency option pricing to demonstrate that these expectations are systematically related to expected return differentials across assets denominated in different currencies. Because the measured deviations from uncovered interest rate parity are tied to variables which theory links to the risk premium, the results provide substantial evidence that a risk premium does indeed exist, as opposed to the alternative of a violation of rational expectations. However, like previous attempts, the data do not support an explicit mean-variance formulation of the risk premium.

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