Can Currency Risk Be a Source of Risk Premium in Explaining Forward Premium Puzzle? Evidence from Asia-Pacific Forward Exchange Markets

This paper studies time-varying price of risk and volatility in Asia-Pacific forward exchange markets in an attempt to see whether currency risk can be a potential source of risk premium to explain forward premium puzzle. To derive a measure of the risk premium, a conditional version of international CAPM (ICAPM) in the absence of PPP is estimated and the parameter restrictions are tested based on asset pricing theories. To incorporate time-varying feature of the risk premium into the model, not only are the second moments of asset returns allowed to change over time by utilizing a parsimonious parameterization of the asymmetric multivariate GARCH with conditionally t-distributed error process (MGARCH-t), but also the prices of risks are permitted to evolve through time based on some predetermined information variables. Estimation results indicate that the not only are currency risks priced, but also change over time. In addition, the explanatory power of the model measured by pseudo-R^2 is relatively high with an average of 38.211%, suggesting that the predicted time-varying forward risk premia are both statistically and economically significant. Finally, both forward premium and its squared are statistically significant in describing the dynamics of currency risk prices, implying the non-linearity of forward risk premium, which sheds a new light in the estimation of international asset pricing model and on the test of forward premium puzzle