Non-Parametric Estimates of the Foreign Exchange and Equity Risk Premia and Tests of Market Efficiency

It is widely thought that neither the foreign exchange markets nor equity markets are efficient, in the sense that tests of the unbiasedness hypothesis and of the present value relationship, respectively, typically lead to rejection. Interest has therefore turned to whether a risk premium exists. This paper provides non-parametric estimates of the foreign exchange and equity risk premia, i.e., estimates that do not depend on any particular model of risk. The average risk premia for three exchange rates (the DM, Yen, Pound are all against the Dollar) and for four stock markets (West Germany, Japan, the United Kingdom and United States) over 1973-88 are shown to be quite small. In contrast, considerable variation is discovered in these risk premia during this period.