A Latent Factor Model of European Exchange Rate Risk Premia

The floating of a number of European currencies in 1992-93 created a new body of data on risk premia on floating exchange rates. In this paper, excess returns to investments in SEK, NOK, FIM, GBP, ITL and EPT against the DEM are investigated. We model the risk premia as functions of time varying second moments. First, univariate GARCH-M models are estimated for each currency. It turns out that excess returns are significantly higher in times of higher conditional variance for five of the six currencies investigated. Then a latent factor GARCH model that takes common effects in the different currency markets into account is applied. We use a Kalman filter to identify the unobservable risk factors and find evidence of risk premia in the sense that expected excess returns are higher in times of high conditional volatility of the factors. Expanding the model from one to two unobservable risk factors dies not improve the fit significantly. While the average magnitude of the risk premia is o.1-0.4 percentage points per year, they may reach 4-5 percentage points in times of high risk.