An Investigation of Risk and Return in Forward Foreign Exchange

Robert J. Hodrick

52 citations0/0 files storedNational Bureau of Economic Research

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Financial Markets and Investment Strategies Monetary Policy and Economic Impact Financial Risk and Volatility Modeling

Abstract

This paper examines the determination of risk premiums in foreign exchange markets.The statistical model is based on a theoretical model of asset pricing, which leads to severe cross-equation constraints.Statistical tests lead to a rejection of these constraints.We examine the robustness of these tests to time variation in parameters and to the presence of heteroskedasticity.We find that there is evidence for heteroskedasticity and that the conditional expectation of the risk premium is a nonlinear function of the forward premium.Accounting f or this nonlinearity, the specification appears to be time invariant.Out of sample portfolio specu1aton f.s profItable but risky.

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References

1977A critique of the asset pricing theory's tests Part I: On past and potential testability of the theory 1979An intertemporal asset pricing model with stochastic consumption and investment opportunities 1980Forward Exchange Rates as Optimal Predictors of Future Spot Rates: An Econometric Analysis 1976The Valuation of Uncertain Income Streams and the Pricing of Options 1982Interest rates and currency prices in a two-country world 1981A model of international asset pricing 1981Flexible Exchange Rates, Prices, and the Role of "News": Lessons from the 1970s 1981The "Speculative Efficiency" Hypothesis

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1990Re-Interpreting the Failure of Foreign Exchange Market Efficiency Tests:Small Transaction Costs, Big Hysteresis Bands 1987Peso Problems, Bubbles, and Risk in the Empirical Assessment of Exchange-Rate Behavior 1987New Hope for the Expectations Hypothesis of the Term Structure of Interest Rates 1986The unbiasedness hypothesis in the forward foreign exchange market: A specification analysis with application to France, Italy, Japan, the United Kingdom and West Germany

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