Conditional Volatility of Exchange Rates and Risk Premia in the EMS

This paper aims at investigating the behaviour of risk premia of currencies participating in the European Monetary System (EMS) aginst the dollar. For this purpose a multivariate GARCH-in-mean model is specified, allowing the risk premia of EMS currencies other than the deutschmark to be determined as a function of their conditional covariance with the deutschmark/dollar exchange rate. The risk premium of the latter is determined by its own conditional variance. The model is able to capture the time-varying character of the relationship between EMS currencies and the deutschmark. Furthermore, the model allows us to examine how changes in the conditional variances and covariances of future exchange rates affect the level of current exchange rates