Asset pricing and foreign exchange risk: econometric evidence for the G-7

This paper uses an error correction model (ECM) to examine the dynamic, behavioural relationship between the excess returns of foreign exchange and the variables that measure the stock market risk factor. The test results for the major currencies of the G-7, over the period January 1982 to January 1994 support the hypothesis that the excess Foreign exchange returns are related to relative risks of the two national equity markets and hence supports the notion of a risk premium in foreign exchange markets. In addition we find evidence of non-monotonic adjustment in some of the equations with respect to the US dollar which suggests some short-run exchange rate overshooting. (C) 1998 Elsevier Science B.V. All rights reserved.