EQUITY RISK PREMIA AND THE PRICING OF FOREIGN-EXCHANGE RISK

We investigate the relation between the risk premia observed in forward foreign exchange markets and international equity markets using the Arbitrage Pricing Theory. If returns on well-diversified equity portfolios explain movements in agents' intertemporal marginal rate of substitution, then the time variation in forward risk premia should be explained by the forward contract's sensitivity to the equity portfolios and the time variation in the risk premia of those portfolios. We find that equity and forward risk premia are related, but that forward contracts have a component of their conditional mean returns unexplained by their relation to equity factors.