Foreign exchange risk premia over short and long horizons: Frequentist and Bayesian perspectives

The first chapter analyses the behavior of the foreign exchange risk premium using long-horizon regressions. The regressions are able to explain a large portion of the variation of foreign exchange excess returns using instruments that have been shown to predict domestic asset returns. I discuss reasons why the long-horizon regressions will have good power to detect time-varying foreign exchange risk premia and thus may be used even with the limited time span of international data. I also undertake a careful small-sample study to examine the size of the statistics and provide evidence of the increased power. Using the results, I show that Fama's (1984) finding that the variability of the risk premium is greater than that of the expected change in the spot rate holds even for horizons extending out to four years and is, therefore, not the result of market frictions which would bind only in the short run. I show that both the length of the holding period and the inclusion of global and local risk factors are important for tests of latent variable models.; The second chapter analyses currency hedging for international equity portfolios. I focus on conditional portfolio and hedging decisions by using a recursive vector autoregression model to identify a shock arising in the money, equity or currency markets. The results reveal that money and equity market shocks cause longrun movements in both equity and currency returns. The approach is Bayesian so an investor accounts for the large amount of parameter uncertainty while incorporating his beliefs about international asset return predictability. Despite having priors that are strongly weighted against the predictability of both equity and currency returns, asset market shocks cause the investor to shift his portfolio allocation and hedging strategy in order to maximize his expected utility. I can isolate the economic significance of the predictability of currency returns from that of equity returns by having the investor manage a currency overlay portfolio.