Asset Price Based Estimates of Sterling Exchange Rate Risk Premia

Abstract:     
In this paper we report estimates of the effective sterling, sterling/Deutsche mark and sterling/US dollar risk premia over a monthly 1987-2001 sample, generated using a conditional factor model for the stochastic discount factor of a representative worldwide investor. The model relates this stochastic discount factor to the real return on a worldwide stock portfolio, with the model parameters varying with variations in the slope of the world term structure of interest rates. Econometric tests indicate that this model is accepted by the data. The corresponding parameter estimates are used to compute the risk premium for the three aforementioned sterling exchange rates. A graphical analysis indicates that, in terms of magnitude, our measure of the exchange rate risk premium is mainly of importance for the sterling/Deutsche mark exchange rate. Risk-adjusted test regressions for uncovered interest rate parity vis-a-vis the major European currencies provide some confirmation for this.

Number of Pages in PDF File: 36

Keywords: Uncovered interest rate parity, exchange rate risk premia, conditional linear factor models, habit persistence in consumption

JEL Classification: F31, G12, G15

working papers series