CAN A TIME-VARYING RISK PREMIUM EXPLAIN EXCESS RETURNS IN THE FORWARD MARKET FOR FOREIGN-EXCHANGE

We investigate the existence of a time-varying risk premium in the foreign exchange market using the intertemporal asset pricing model. In this model the risk premium is due to consumption risk, which is measured by the covariance between returns and the marginal utility of money. We model this conditional covariance using Engle's (1982) ARCH model. Results are presented for three exchange rates for the 1975-1985 period. Although a time-varying risk premium is an important determinant of the expected returns, tests of IAPM restrictions show that a more flexible specification of the model is needed. © 1990.