Tests of the foreign exchange risk premium using the expected second moments implied by option pricing

This paper applies a new method to investigate the foreign exchange risk premium. The method is new in the sense that it utilizes the time-varying second moment expectations implied by foreign currency option pricing. The vast empirical literature on the risk premium generally neglects the role of time-varying second moments, in spite of their importance in assessing risk-return tradeoffs. In fact, this importance is borne out in the data: time-varying expectations generate valuable new evidence regarding both unbiasedness in the forward rate and portfolio balance models. Moreover, the results suggest that previous tests which assume constant second moments involve serious misspecification errors. The results also highlight the unreliability of the portfolio balance effects of sterilized intervention, in spite of the quantitative importance of expected return differentials.