Testing for the Presence of Time-Varying Risk Premium Using a Mean-Conditional-Variance Optimization Model.

This paper develops a version of the mean-variance optimization model that yields three equilibrium conditions: covered interest parity (CIP), forward rate unbiasedness (FU) and uncovered interest rate parity (UIP). The last two hold in the standard fashion only when agents are risk neutral. The exchange risk premium depends on the conditional variance of the future spot exchange rate. This is generated by a GARCH (1.1) Model. Using the Phillips and Hansen (1990) estimation and inference procedures, we find that CIP holds, while the UIP and FU can be rejected only for the Japanese yen. Evidence of the presence of time varying risk premia is found in the Deutschemark and the Japanese yen. All the variables for the three relationships are found to be cointegrated. Copyright 1994 by Blackwell Publishing Ltd